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Four phases of the life-cycle
1 Four phases of the life-cycle
1.1 Learning outcomes
After studying this text the learner should / should be able to:
1. Describe the phases of the life-cycle of the individual.
2. Elucidate the codes / rules that pertain to each phase of the life-cycle.
3. Discuss the other codes / rules which apply throughout or during part of your life-cycle.
1.2 Introduction
In this text we present four main sections:
• Four phases of the life-cycle.
• The financial system.
• Investment instruments.
• Investment principles.
The following broad categories and subcategories of investments exist:
• Ultimate investment instruments:
-- Financial investment instruments (issued by ultimate borrowers):
• Debt instruments.
• Share (aka stock and equity) instruments.
• Real investments:
• Property (also called real estate).
• Commodities.
• Other real investments (art, rare coins, antique furniture, etc.).
• Indirect investment instruments (issued by financial intermediaries):
-- Issued by banks: deposit instruments.
-- Issued by quasi-financial intermediaries: debt instruments.
-- Issued by investment vehicles: participation units/interests.
We will discuss them in some detail. As the majority of portfolios are made up of financial investments,
we pay special attention to the financial system from which they spring. In the last main section, we
discuss issues such as the objective of investments, the relationship between risk and return, and portfolio
management. We also touch upon the investment theories and extract from them the tried and tested
principles of investments, such as diversification, the valuation of assets, and so on.

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Four phases of the life-cycle
The above is of little use if one does not have investments. Only a small percentage of people (some studies
say 6–10%) reach their financial security goal (FSG), and are able to replace formal work with other
activities. For this reason we present upfront a discussion on the life-cycle, i.e. the four phases of life and
the “rules” of the four phases that should be followed in order to achieve your FSG at an appropriate age.
There is a body of literature labelled life-cycle theory of consumption. Its genesis was in the 1950s and
its champions were Franco Modigliani and his student Richard Brumberg, as expounded in papers
published in 1954 and 1980. In essence the theory postulates that individuals make intelligent choices
on the volume of their spending at each phase of their lives, and this is constrained only by the financial
resources available over their lifetime. They tailor their consumption to their needs over the phases,
independently of their income, and in so doing build up and deplete a portfolio of assets during their
lives enabling them to live the last part of their lives (“retirement”) sans recurring income from labour.
This simple theory leads to important predictions about the broader economy.1
The reality is that few individuals are able to reach their financial FSG, and the majority are dependent in
the last phase of their lives on sources of income unrelated to themselves (usually their children / friends /
government social security). We define “reaching your FSG” as building a portfolio of assets during the
labour (income-earning) phases to a size that will sustain the individual and his/her dependent/s during
the non-labour phase (“retirement”). Some individuals wish to reach their FSG early at, say, 40 years of
age, while others wish to pursue an occupation until they are no longer able to.2
The above can be put another way: individuals have a life-long budget constraint and endeavour to
spread income earned during the labour phases over their remaining lifetime. This means that part of
consumption is deferred during the labour phases; and the degree of deferring affects when the FSG is
attained. Financial assets represent the vehicles for transferring consumption to the future, and financial
liabilities (loans) are the vehicles for transferring future consumption to the present.
Thus, there are many choice-variables over the life-cycle, and they include:
• Income from labour (how to maximise it; how to guard / insure against disability / death).
• Expenditure / consumption (how to minimise; shift part to the future).
• Saving and building a portfolio of assets (the above apply in terms of how quickly; how to mix
risky and risk-free assets = asset allocation decisions in various phases; how to hedge against
inflation and contingencies).
• Debt / loans (the extent to which one is able to fast-forward “consumption” – here meaning
the purchase of an essential asset, a dwelling).

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Four phases of the life-cycle
A well-known statistic (of a large life assurance company) is that less than 10% of individuals reach their
FSG. The reasons for this poor state of affairs are many, and they relate to neglecting the obvious codes
or rules of behaviour [financially and otherwise (which affects the former)] which should be followed
over the phases of their lives.
This text does not expound on the life-cycle theory; rather, it endeavours to postulate the codes or
rules of behaviour (financially and otherwise) to be adhered to over your life-cycle. This is followed, in
subsequent texts, by various related subjects (such as risk and return and asset valuation) that form an
introduction to investments. Investments are of course irrelevant if you do not follow the codes / rules,
because you will not have a portfolio of assets. If you do, having an understanding of investments cannot
be overemphasised, even if you outsource the management of your portfolio.
It will be evident that individuals require three forms of security:
• Personal security.
• Health security.
• Emotional security.
• Financial security.
The financial security goal (FSG) is at the forefront of people’s minds (or should be), and can only be
achieved by following the rule that income must always be greater than expenditure (I > E). Debt can
be part of the equation but only to the extent that debt is undertaken for good reasons (such as the
purchase of a home) and that debt servicing (i.e. interest payments) is incorporated into E such that
the condition I > E prevails. It will be evident that savings (S) is the outcome of I > E, and therefore
that I > E = +S, and that the achievement of one’s FSG at an appropriate or desired age is a function of
maximising I and minimising E.
Because of our physiological and psychological hard-wiring and our environment, there is a pattern to
our lives: we are born (0 years), nurtured and educated by our parents, expelled from home at 20+ years
of age, undertake a career in order to survive, choose a life partner, have children who need nurturing
and education (who are then ejected from the nest when we are 40–45), get too old to work effectively
at 60+ years of age), and then depart for Heaven (some believe) at 80+ years’ of age. We therefore have
four phases to our lives:
• 0–20 Newborn to adulthood.
• 20–40 Adulthood to maturity.
• 40–60 Maturity to seniority.
• 60–80+ Seniority to exodus.

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Four phases of the life-cycle
These phases are approximate because each person has a different life-script. Each phase has distinct
characteristics / needs / desires and which need to be recognised, accepted and managed – especially in
respect of our financial life – if you are to reach your FSG at a desired age.
Figure 1 portrays the ideal financial scenario for achievement of your FSG. It is self-explanatory. Below
we discuss the “rules” of each phase.
Income from
work
Expenditure
Saving
Age
0 20 40 60 80
This (compounded)
finances
Phase 1 Phase 2 Phase 3 Phase 4
Departure
forHeaven ?
Income,
expenditure,
saving,
debt
Newborn to adulthood Adulthood to maturity Maturity to seniority Seniority to exodus Injury time
Figure 1: four phases of life
Figure 1: four phases of life
1.3 Phase 1: newborn to adulthood (0–20)
1.3.1 Introduction
This phase has been called “creating capacity”3
and “becoming somebody”4
. It is the phase over which
you have little control (except in the latter part). You cannot choose your parents, so hopefully you will
have had good parenting. What is good parenting? It is providing the child with a solid foundation for the
life s/he will build for himself/herself. What are the rules for providing children with a solid foundation?
They can be summarised as follows:
• Read up on the cognitive development stages of offspring.
• Promote a rock-solid emotional backbone.
• Provide sound education inside and outside institutions of learning.
• Programme the child’s mind to be an inquiring one.
• Promote an ethos of sound money management.
• Drive home the philosophy that wealth has two legs: monetary and non-monetary.

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1.3.2 Read up on the cognitive development stages of offspring
Raising one’s offspring is centred on learning: from parents, the environment and institutions of learning.
While the latter are the authorities on “when the child leans what”, the parent usually is not. Therefore, it
is important to have an understanding of the cognitive development stages. Jean Piaget5
, a development
biologist, devoted much of his life to the cognitive (i.e. learning, in the widest sense) development of
infants, children and adolescents. He identified four stages, now known as the four stages of Piagetian
development:
• Sensory motor stage (aka Sensorimotor stage) (0–2 years).
• Preoperational stage (2–7 years).
• Concrete operational stage (7–11 years).
• Formal operational stage (11–adulthood).
Sensorimotor stage (0–2 years)
Infants are “ego-centric”: they are not able to consider others’ needs, wants or interests. They acquire
knowledge about objects and the ways that they can be manipulated, and begin to understand how one
thing can cause or affect another. They also begin to develop simple ideas about time and space.
Preoperational stage (2–7 years)
Children’s thought processes develop in this stage, although they are still considered to be far from
“logical thought”, in the adult sense of the word. The vocabulary expands and develops during this stage,
and they change from babies and toddlers into “little people”.
A characteristic of this stage is “animism”: when a person has the belief that everything that exists has
some kind of consciousness. An example: when a child runs into a piece of furniture s/he will punish it,
because it behaved badly in that it hurt them. They tend to assume that everyone and everything is like
them; therefore, because they feel pain and have emotions, everything else does too.
Children start this stage as “ego-centric” but gradually a certain amount of “de-centering” transpires.
Concrete operational stage (7–11 years)
During this stage, the child’s thought process becomes more rational, mature and “adult-like”, or more
“operational”, and often continues well into the teenage years. Belief in animism and ego-centric thought
tends to decline (although remnants are often found in adults). They are able to evaluate the logic of
statements by considering them against concrete evidence only.

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Four phases of the life-cycle
Formal operational stage (11–15+ years)
In this stage adolescents are able to reason beyond a world of concrete reality to a world of possibilities,
and to operate logically on symbols and information that do not necessarily refer to objects and events
in the real world. They can focus on verbal assertions and evaluate their logical validity without making
reference to real-world (concrete) circumstances.
1.3.3 Promote a rock-solid emotional backbone
The second rule is the promotion of a rock-solid emotional backbone6
. It is reflected in a high level of
self-confidence and self-esteem. Providing a child with this life asset is firmly in the hands of parents
and is a result of many factors, including the frequent expression of unconditional love, acceptance of
the child as s/he is, and creating a sense of personal security.
1.3.4 Provide sound education inside and outside institutions of learning
The third rule is to provide children with a sound education inside and outside institutions of learning.
Outside of academia (i.e. at home) parents should promote / encourage:
• Achievable personal standards: encourage achievements to the best of the child’s abilities, and
not beyond. Do not compare the child to other children7
.
• A strong sense of self-reliance and responsibility.
• A balanced life: exposure to sport and art, in addition to academics.
• A sound moral compass.
The latter is imperative, and includes the sound values of integrity and honesty. From a young age the
child should know that integrity moulds ones personal brand, and that only the truth can be recalled
(lies cannot).
1.3.5 Programme the child’s mind to be an inquiring one
The fourth rule is to encourage children to have a life-long enquiring mind. Children need frequent
parental contact and stimulation from birth. In the preoperational stage (2–7 years), usually at ages 3–5, a
child’s mind is developed to a stage where s/he is highly stimulated by his/her environment, as reflected
in the rapid-fire numerous questions put to parents.
A life-influencing, crucial error made by many parents is to discourage the questioning (a result of
possible irritation) or to provide meaningless answers. It is critical to answer questions well, to consult
encyclopaedias when one does not know the answer (which must be done with the assistance of the
child), and to encourage further questions.

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Four phases of the life-cycle
As the reader of this text is most likely a young adult, who had limited or no control of phase one, why
do we mention the above here? The reasons are:
• You are partly in control. You decide on your education and the extent to which you prepare
yourself in this regard for the next phases. Interpersonal relationships are also in your ambit
of control. Also, you do have an “income” (usually a parental allowance), which enables you
to get going on the ethos of sound money management (I > E = +S).
• You will most likely have children one day; in fact you are hard-wired to procreate, i.e. to
propagate yourself and your partner. It is difficult to resist the urge despite the hardship and
expense involved in raising children.
• Your success in your career and your personal finances in later life reflect your self-confidence
and self-esteem built in this phase. If this life asset was not properly established in this phase,
it is advisable to seek professional help from a psychologist.
A wealth management company, Citadel, recently undertook substantive life-phase research amongst
their clients. The outcome was that all the clients taken on had been good-parented. Many of them grew
up in financially modest circumstances, but were imbued with emotional security.8
1.4 Phase 2: adulthood to maturity (20–40)
1.4.1 Introduction
This phase has been called the “rollercoaster”9
and the “high-speed low-wisdom”10
phase. It could also be
called the “make or break” phase of your life. Your personality is established and your basic education is
in place. You will leave home and are now in control of your own life. You will almost certainly choose
a life partner / spouse and have children. This is also the phase when your income rises at the fastest
rate – provided you follow the tried and tested “rules of the game”. The “rules” are:
• Choose your career with care.
• Undertake one career and become accomplished at it.
• Undertake lifelong continuing education.
• Choose your life partner with care.
• Nurture your health and family life.
• Underspend.
• Insure your life only
• Take on debt, but with much thought.
• Do not bow to peer pressure.

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1.4.2 Choose your career with care
Analyseyourpersonalityprofilecarefully(orhaveitdoneprofessionally),acknowledgeyourstrengthsand
weaknesses, and match them with your career. A career is an employee-position (e.g. a bank employee),
a profession (e.g. a lawyer) or a business (e.g. manufacturing plastic products, including vuvuzelas).
Because this is probably the most important decision of your life, and it will occupy you for 40+ years,
it must resonate with your passion/s.
1.4.3 Undertake one career and become accomplished at it
Assuming you have discovered your passion, undertake one career and have as a goal to be the best at it.
Because you are not able to manufacture more time, and because you have one quantity of energy, focus
all your attention on your one career and be jealous of your time. In this phase of your life you will be
tempted to coach rugby and serve on the school board; these deserving activities divert your attention.
Put them off until phase three when you will have the time.
If you are an entrepreneur with your own business, you are by definition a risk-taker. Take risk only in
this phase because you can make up losses, a luxury which you do not have later in life.
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If your career is, for example, a bank employee, set your sights high because you can do exceptionally
well financially as an employee. Remember the following:
• The job must accord with your abilities and personality.
• Do not for a moment think that you do not have risk; risk exists in that you can lose your
employment.
• It is advisable to regard your job as a one-man (your) business and that your salary is the
settlement of an invoice you issued to your employer for services rendered by you. This will
make you serious about your job.
• Respect your owner-employer; s/he is the principal risk-taker in the business.
• Because you have to be at work in any case, work diligently, be punctual, go the extra mile,
find solutions to problems, and be a team-player.
1.4.4 Undertake lifelong continuing education
Your education does not end with obtaining a first degree or diploma. Your career requires investment
in all its aspects, in the form of formal (further degrees, diplomas) and non-formal education. The latter
entails being a good listener of the opinions of others who are more experienced, reading and travel.
Your goal should be to be the most informed of any person in the industry. General knowledge, gained
from wide reading of non-fiction, makes you an engaging person, which is an essential ingredient of
success in your business / job and your personal life.
Read only non-fiction in this phase (fiction can enjoyed when you have achieved your FSG), i.e. stay up
to date with developments pertaining to your career and with your country and world developments.
Observe and understand your world. Engage in dialectical interaction. This means debating, which
must always be non-confrontational: stating a thesis (hypothesizing), listening to an offered anti-
thesis, and synthesizing a new thesis. This is true open-minded learning and makes you an engaging
conversationalist.
1.4.5 Choose your life partner with care
You are “wired” with the emotion “love”, to be attracted to another person, to marry that person, and
to have children (usually). With marriage, you sign the most significant and enduring contract of your
life, and you live with this other person for 50–60 years. This other person is an individual who has
opinions, passions and idiosyncrasies often different from your own. The divorce statistics indicate that
most marriages fail.
An unhappy spouse and a divorce can affect your career, your finances and your offspring in a devastating
fashion. In many cases divorce leads to a doubling of expenses (two homes) and a halving of income /
assets. The consequences for your FSG can be profound.

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Four phases of the life-cycle
Given the high price of housing and good education, it is more usual that both partners / parents are in
employment / own businesses. It is therefore important to choose a life partner who is well educated.
This is especially the case when one considers the possibility that one of the partners / parents may pass
on or become disabled. This also has implications for life insurance (covered below).
1.4.6 Nurture your health and family life
This rule ties in with being jealous of your time. You only have a certain quantity and quality of energy.
You need to undertake a life-long programme of maintenance of your energy level by participating in a
physically-demanding sport. A fit person is a competent co-breadwinner / breadwinner.
Your career and sport take up time and what is left over should be devoted to your spouse (a good marriage
demands effort) and children in their required nurturing. For these reasons avoid at all costs becoming a
workaholic, because work can become addictive. A good balance between your career, sport and family
life makes you a better spouse, parent, friend and colleague. A person who consistently spends eighteen
hours a day at work is being irresponsible. It is incongruous that workaholics boast of this attribute.
1.4.7 Underspend
The personal finance equivalent of the property market’s axiom “location, location, location” is
“underspend, underspend, underspend” and this should become a lifelong mantra. While there are many
demands on income, it is essential to start off this phase with an I > E = +S approach. Underspending
should become a persistent financial state because it facilitates attaining one’s FSG at an earlier stage.
The rule of thumb is save 20% of income. The condition I < E leads to ruin.
1.4.8 Insure your life only
Part of underspending is to avoid overinsuring. Some insurance saleswo/men will pressure you to
purchase many different policies, because they are usually remunerated on a commission basis and/
or their bonuses are a function of their targets. There is a need for pure life/disability insurance, house
insurance, house debt insurance, and possibly car insurance, but avoid the rest. Your priority in this
phase (and the next phase) is to repay debt as quickly as possible (see next section).
As to the extent of life/disability insurance: you will have a spouse and children; insure against debt,
and your life / your disability, for an amount that is sufficient to cover household expenditure until your
spouse is able to provide for them. The latter is dictated by the ages of your children and the level of
education of your spouse; your spouse may need to advance his/her education in order to better provide
for the children and him/herself.

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Four phases of the life-cycle
Pure life insurance is termed risk life assurance (RLA), and it is differentiated from policies which combine
RLA and investment assurance. The reason for separating RLA and investments is that your investment
and RLA requirements change as you age.11
Generally, as you age and your assets increase your RLA
needs decrease. It can be expensive to change combination policies, whereas there are no penalties for
cancelling RLA policies.
There are various RLA policies, including12
:
• Whole life assurance.
• Term assurance (increasing, decreasing, convertible).
• Credit life assurance (covers debt).
• Joint-life assurance.
• Disability assurance.
• Impairment assurance.
• Critical illness / dead disease assurance.
• Terminal illness assurance.
1.4.9 Take on debt, but with much thought
You need a home and a vehicle and you will need to incur debt to acquire these (see Figure 2). It is
important to ensure that the debt service (i.e. interest) amount, which is part of E, is such that the
condition I > E is upheld.
Income from
work
Expenditure
Saving
Age
0 20 40 60 80
This (compounded)
finances
Phase 1 Phase 2 Phase 3 Phase 4
Departure
forHeaven ?
Income,
expenditure,
saving,
debt
Newborn to adulthood Adulthood to maturity Maturity to seniority Seniority to exodus Injury time
Figure 2: four phases of life
DEBT
(different
scale)
Figure 2: four phases of life

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Four phases of the life-cycle
It is wise to live in a modest home and drive a modest car, because this keeps E at a low level. If there is
a comfortable excess (S) over time, repay debt at a faster pace. If you have a business, borrow only if your
business plan is sound, and reduce the debt asap. If you are an employee and are offered shares / options,
sacrifice income or borrow if this is the way to buy the company shares or share options. However, only
do so if you and your colleagues “believe” in the business. In these ways assets are built.
At all costs avoid buying lifestyle assets with borrowed money, even if E can accommodate the additional
debt servicing cost. Rather repay your mortgage debt at a faster pace. Keep in mind that owning a boat
or a holiday house is not wise; they can be hired and E will be lower and S+ higher.
1.4.10 Do not bow to peer pressure
Do not be influenced by your peers; in fact set the (modest) standard for your peers and friends. You
will be surrounded by peers, and many of them will have impressive visible assets, such as a large home
and expensive vehicles, as well as lifestyle assets such as a boat and a holiday house at the seaside. Many
of them will also take their families on expensive overseas holidays. Keep in mind that the visible assets
are the asset side of the balance sheet, and that the liability side, which funds the asset side, is invisible.
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Bowing to peer pressure is especially rife in the professional fraternity, and many of them are obliged
to continue in their professions until a late age. This is not a pitiable situation (because it is advisable
to remain active), but it is most satisfying to have the option to live off savings. By all means have a
comfortable lifestyle, and acquire lifestyle assets, but only when you can comfortably afford them.
1.5 Phase 3: maturity to seniority (40–60)
1.5.1 Introduction
This is sometimes called the “consolidation”13
phase. It is the phase when the children leave home and, as
shown in Figure 40, your expenditure falls while your income continues to increase, but at a lower rate.
This is so because your business will most likely have reached maturity and is highly profitable by this
stage, or you will have advanced well as an employee – in many cases to close to the top of the hierarchy.
This of course assumes that you followed the rules that pertain to phase 2. Consequently, it is the time
when gap between I and E increases and you will be saving more than the amounts possible in phase 2.
Your FSG is getting closer and you are in a position to ensure that you will reach it in this phase, provided
you follow the rules that pertain to this phase:
• Nurture and exploit your personal brand.
• Aggressively repay debt.
• Cash out and separate business risk from personal assets.
• Invest assets wisely.
• Finance lifestyle assets with excess funds.
1.5.2 Nurture and exploit your personal brand
At the start of phase 3 you will have built a personal brand – either as a business person, a professional
or an employee. It is the most valuable of all non-monetary assets and should be used to propel you to
the top in your chosen career. This will ensure that I will continue increasing at a time when E is falling,
and this will enable you to repay debt.
It is important not to fall into the trap of arrogance which could quickly destroy your brand and your
wealth in phase 3. Success in phase 2 leads many people at age 40+ to believe too much in themselves
(invincibility!); this arrogance affects decisions on risk-taking and expenditure detrimentally. Rather
attempt to identify arrogant people with the purpose of avoiding them.

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1.5.3 Aggressively repay debt
Higher I and lower E will put you in a position to repay debt at a faster rate (see Figure 2). It is likely
that you enter this phase with a large outstanding mortgage bond. The highest return you can get on
savings is in the share market: in the long term it delivers a mean return of over 12% pa; as you know
this return is accompanied by risk (= variability of return around the mean). If your debt is costing you
12% pa and you apply all your savings to paying off your bond you are “earning” 12% pa without any
risk. It is a superior deal. In fact, given the risks in the share market, it pays you to repay your bond even
if the rate is 9.6% pa, because this can be called a risk-adjusted rate (RAR). If in the 12% share market
the STD = 20%, the RAR = 9.6% pa.
This is also the phase when your parents pass on and leave you an inheritance (if they have not SKI’d14
it away). Regard this money as a windfall and use it to repay debt.
It should be a rule that at age 45–50, all debt should have been repaid. Given a sharp increase in net assets
in this period there will be temptations (from the bank and peers) to buy lifestyle assets; avoid them.
1.5.4 Cash out and separate business risk from personal assets
During this phase your net worth will grow sharply and it is important to “cash out” a portion of your
non-diversified assets and separate business risk from personal assets. How this is achieved in the different
careers requires separate discussion.
If you are an employee with share options, cash out a portion and diversify (i.e. reduce risk) (more on
this later). You should also be acutely aware in this phase that you are vulnerable. Downsizing of your
employer-company in a recessionary period may lead to your retrenchment. This can be a serious setback
to the timing of your FSG. You need to actively seek to expand the business of your employer by using
your brand and wisdom, and recommending the employment of keen youngsters. The company owners
will reward you with an extension of your working life. But you have to recognise that you must remain
relevant. The company owes you a salary only if your earn it.
If you have a business or are a professional the separation of business risk from personal assets is achieved
by, over time, identifying and handing the reins of the business over to youngsters with new expertise
and energy. Your energy level will be lower than before and you need to recognise this upfront. Sell a
portion of the business to them and sell more as you get older. Go back to your area of expertise in the
company. The Bill Gates example is relevant; he handed over the reins and went back to his passion,
software creation. The youngsters will respect you and most likely reward you with the chairmanship –
but only if you have kept yourself relevant to the business. Thus, you will have prolonged your income-
earning period.

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Four phases of the life-cycle
1.5.5 Invest assets wisely
As you become a high net worth (HNW) individual and you have separated business risk from personal
assets you will need to make decisions on investments. One of them is the choice of management of
your money between self-management and external management. In the former case you will need to
undertake extensive and ongoing research, which is extremely time-consuming. You should only consider
this option when you have reached your FSG. However, the majority of persons who are successful in
terms of their FSG use external management, which amounts to taking external advice. In this regard
there are 2 options:
• Appoint a fund management firm (stockbroker or specialist firm).
• Invest in securities unit trusts (SUTs) and exchange traded funds (ETFs).
In the former case there are certain rules to follow, the most important of which is to choose the right
manager, and this must be based on past performance. However, even excellent fund managers make
bad decisions at times. For this reason it is good practice to implement the golden rule: diversification,
i.e. choose 2–3 managers. The managers will in turn also diversify your investments. As you know this
route takes advantage of low or negative correlations of return and reduces risk.
The D. E. Shaw group is hiring.
You can do the math.
Meet us on-campus this semester.
Check out www.deshaw.com for more info.

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Four phases of the life-cycle
1.5.6 Finance lifestyle assets with excess funds
Most HNW people are tempted to buy a large motor vehicle, a larger home, a boat, a holiday house at
the sea and take long and expensive holidays. Only consider these if you have reached your FSG and
have excess funds. However, consider the facts:
• A larger motor vehicle is expensive to run and insure, and it is difficult (emotionally) to
downgrade if you have to.
• A holiday home restricts one’s travel options because you feel obliged to use it every year.
• A holiday home is a non-earning asset, i.e. a poor investment even if you can afford it. It is
wiser to rent a holiday home each year and it enables you to diversify your travel destinations.
1.6 Phase 4: seniority to exodus (60–80+)
1.6.1 Introduction
This phase has appropriately been called “the sunshine years”15
. The age of 60 is probably a good target
for attainment of your FSG, because it is the age when most people’s energy levels begin to wane, and
they get the urge to exit their job or business and to play a sport fulltime, or to start a new career. This
phase only starts when you have reached your FSG. Some people will start it at 60, while others will
start it at 65 or even later. The rules for this phase are:
• Choose this day carefully and prepare yourself emotionally.
• Continue to invest assets wisely.
• Resist the Indiana Jones temptation to make a comeback.
• Do not lend money to anyone.
• Undertake SKI holidays.
1.6.2 Choose this day carefully and prepare yourself emotionally
The age at which you start off this phase is dependent upon your success during the past two phases. As
indicated in Figure 40 income ceases at the start of this phase. Thus, expenditure is financed from one
source: your portfolio (retirement fund and/or personal portfolio). It is important to note that while
expenditure falls over time, it does not fall sharply. This is a result of medical expenditure rising, while
normal consumption expenditure falls. If your portfolio is able to sustain your partner and yourself
comfortably (which includes travel) you have reached your FSG.

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Four phases of the life-cycle
If you are fortunate to have achieved your FSG, which you will know before the start of the phase is
reached, it is imperative that you prepare carefully for a new life in the form of hobbies, sport or a new
career for which you have never had the time. In the case of a new career, it is liberating to not have
to earn an income. One rewarding prospect is teaching, i.e. to give young people the benefit of your
experience and wisdom. If you do not prepare for this, it is likely that you will become depressed and
depart life prematurely. There is an undisputed link between depression and cancer.
If you have not reached you FSG at age 60+, you will need to keep yourself relevant or re-skill yourself
in a field appropriate to your experience. To be avoided at all costs is to invest your portfolio in risky
assets (including a new business, such as a coffee shop or a fishing tackle shop at the sea).
1.6.3 Continue to invest assets wisely
It is even more essential to focus on investing assets wisely and to allow for bear markets. As noted, it
is wise to take objective advice and not be emotionally involved with your investments. However, if you
are well-schooled in the investment industry it is likely that you will embrace self-management. In this
case you will need to make the broad asset allocation, and choose the investments in each asset class.
Let’s examine an example: you believe that the economy is robust and that asset prices will increase. You
have a mortgage-free home and do not think it wise to have any further investment in property (because
property is an illiquid investment). You also wish to keep a proportion of your assets in bonds and in cash
(= money market). You require diversification and liquidity. You decide upon a portfolio as presented in
Table 1. (A note: the terms used here are probably unfamiliar; they are elucidated in some detail later.)
With this type of portfolio you have achieved the following:
• Diversification (across 85% of portfolio).
• Taken advantage of the highest return asset class which can be done at the start of the phase
but should be changed as you get older.
• You have risk (in the share market) but it reduces as the investment horizon increases (you
may have 20+ years ahead).
• Kept transactions costs low (ETFs instead of the shares/bonds underlying them).
• Liquidity (in all assets except property and other real assets).

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Four phases of the life-cycle
1.6.5 Do not lend money to anyone
When you have achieved you FSG it is likely that you will be approached by people, including your
children, to invest in a “fail-safe” venture. When this happens place at the forefront of your mind:
• Your portfolio is sacrosanct.
• If you acquiesce your portfolio’s risk and return risk characteristics will change in the direction
of higher risk.
• Moral hazard rears its ugly head: easy money is easily squandered, especially by family, because
there is no pressing need to repay / service interest.
• If the venture is viable (and it should be reviewed), bank funding is available; this is the banks’
business, not yours.
1.6.6 Undertake SKI holidays
Spend the kids’ inheritance. After almost half a century of dedicated work (accompanied by stress), when
you have not relaxed much, it is time to learn to relax. When you depart for Heaven (some believe) at
80–90, your children will be retiring and probably not need to inherit assets.
1.7 Other rules which apply throughout or during part of your life-cycle
1.7.1 Introduction
One is able to identify many other rules that should apply in one’s life. Here we list those we consider
of major importance:
• Do not become dependent on the largesse of your spouse.
• Nurture relationships in business with like-minded people and avoid negatively-focussed
people.
• Be quietly competitive.
• Be kind to people with humble stations (positions) in life.
• Read up on the undisputed “Out of Africa” theory.
• Pursue happiness.
• Have no regrets upon exodus.
• Undertake a lifelong love affair with macroeconomics and the political environment.
1.7.2 Do not become dependent on the largesse of your spouse
Many individuals become dependent upon their spouses in a financial sense and become enslaved –
sometimes in an unhappy home. If your occupation is to nurture the children ensure that your marriage
contract affords you equality in terms of the family assets. If you are career-orientated, resume your
career asap or when the youngest child enters pre-school.

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Four phases of the life-cycle
1.7.3 Nurture relationships in business with like-minded people and avoid negatively-focussed
people
Beware of arrogant and narcissistic people; they are usually intelligent, articulate and persuasive. They
journey through life with the attitude that the world owes them a good living, and ultimately destroy their
lives. The first sign to look for is that they are poor listeners and never enquire about you and your family.
1.7.4 Be quietly competitive
You are hard-wired to compete for position in the hierarchy of business and personal life. Do it without
fanfare, and never burn bridges (except with arrogant and narcissistic people) because you are bound
to meet previous colleagues in the future. Some of them may be in positions that can have a bearing on
your business life.
1.7.5 Be kind to people with humble stations (positions) in life17
You will come across people almost every day that are not as fortunate as you may be. Be cognisant of
the reality that they may not have had the opportunities you had to better themselves. These people are
generally treated with contempt or obliviousness. Mentally project yourself into space and look down
on earth; this will make you realise that we are all diminutive and make only a small contribution to
society. You have no reason, even (or especially) if you are well on your way to, or have already achieved,
your FSG, to feel superior. Kindness begets kindness, joy and helpfulness (humble stations are usually
service positions).
1.7.6 Read up on the undisputed “Out of Africa”theory18
The Out of Africa theory postulates that a small group of Africans left Africa 70 000–80 000 years
ago and populated the world. There is ample evidence [archaeological, mitochondrial (female) DNA,
phylogeographic, palaeontological, etc.] that the small group left what is now Ethiopia / Djibouti and
crossed the sea (then at a lower level) into what is now Yemen. From there they spread across the world.
It has also been suggested that human skins became lighter in colder climes because of the less harsh
sunlight and in order to produce the body’s required amount of vitamin D (which is produced by the skin).
1.7.7 Pursue happiness
Happiness is a choice, a state of mind influenced by myriad factors of which financial health is a significant
contributor. Self-actualisation is the ultimate human accomplishment (according to Maslow) and can
only be achieved with a strong financial state of affairs. In the next section we present a synopsis of a
body of research on the life-cycle of happiness.

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Four phases of the life-cycle
1.7.9 Undertake a lifelong love affair with macroeconomics and the political environment
Asstatedoftenbefore,undertakealifelongloveaffairwithmacroeconomicsandthepoliticalenvironment.
These disciplines provide the framework for investments. Investment returns are driven by earnings and
earnings are driven by:
• Domestic demand (DD) [= consumption expenditure (C) plus fixed investment expenditure
(I) = gross domestic expenditure (GDE)].
• Net foreign demand (NFD) [= foreign demand for local goods (exports: X) less local demand
for foreign goods (imports: M) = trade account balance (TAB)].
• The above make up the expenditure on gross domestic product (GDP).
Thus, the macroeconomy (i.e. the economy seen broadly) is represented by:
DD = C + I = GDE.
NFD = X – M = TAB
GDE + TAB = GDP (expenditure on).
1.8 Life-cycle of happiness20
What is happiness? It is a state of being expressed in many ways, such as psychological well-being, life
satisfaction, emotional well-being, subjective well-being, and so on.
Most adults regard “life” as a long and slow decline from birth to death. What they mean is that people
are happy as carefree / responsibility-free toddlers and teenagers, and then their degree of happiness
declines over time, reaching what is called a mid-life crisis between 40 and 50. The degree of happiness
then declines further until it disappears entirely (= misery) as old age creeps up, and this is so because
old age is accompanied by physical ailments such as painful joints, failing eyesight, memory-loss, etc.,
as well as the happiness-killing thought of dying soon.
This is not the case; rather, research indicates that the happiness life-cycle is U-shaped (see Box 1:
happiness cycle superimposed on the four phases). According to research there are four factors that
impact on happiness:
• Gender. Women are slightly happier than men, but are more susceptible to depression.
• Personality. There are many personality types, with the extremes being neuroticism and
extroversion. The former tend to be unhappy, because they are prone to guilt, anxiety, and
anger, and they tend to be gloomy, and alone. The extroverts are the most happy, because they
form relationships easily, enjoy parties, and take pleasure in working in teams.

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Four phases of the life-cycle
• Circumstances. This factor includes relationships (linking with the aforementioned), education,
income, health and probably the major circumstantial factors: stress and associated worry.
• Age. As we will see, age is a major factor in happiness, and that stress and worry, the major
happiness-inhibitors, are age-related.
BOX 1: LIFE-CYCLE OF HAPPINESS
HAPPINESS
AGE
Illustrations: Colin Daniel, Independent Newspapers
In what follows an important assumption is made: people are emotionally secure, have a home, enough
to eat, a good education, a career, good health, average income, and reach their FSG in their late fifties to
early sixties. This leaves the main factors in happiness to be age and related stress and worry circumstances.
Certainly, babies, toddlers, and pre-teens are happy. This is because they have no responsibilities, except
to pay attention later at school. Teenagers, however, have challenges and therefore stresses and worries:
at school, at home, amongst peers, dating, at social events. Happiness declines under such pressures.
This continues into early adulthood: at university or work.
Making a living can be rewarding emotionally, but it is usually associated with many stress and worry
factors: competition for position, impacting on interpersonal relationships in and outside the work
environment; postponing consumption to later (saving to reach the FSG); long working hours and
associated tiredness; attending cocktail parties and entertaining (to remain part of the network); general
anger at circumstances.

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Four phases of the life-cycle
Happiness declines under these circumstances. However, there are events that give relief at the age of
middle-to-late twenties: marriage, young children and friends. However, the children-factor pales after
a while, as a result of the associated costs (largely unanticipated and therefore not planned for). This
impacts heavily on savings. Children become teenagers, are generally angry, and challenge parents when
they are at their most stressed-out stage: middle forties. Research indicates that the low point, sometimes
called the mid-life crisis, is at median age 46.
Thereafter, stresses and worries remain constant for a while and ease later when the children grow up
and leave home. This stage is associated with a higher disposable income and higher savings, bringing
the FSG closer. The senior stage is reached thereafter.
As people move to senior years they lose vitality and mental sharpness, they have or will have ailments,
and they lose their looks. They look grumpy, as a result of gravity which “pulls” the sides of the mouth
down, and are therefore treated with disdain or are ignored by the young. Older workers are often
placed in unventilated corners with their disregarded opinions. All these disadvantages are a recipe for
unhappiness, but the reality is very different.

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Four phases of the life-cycle
At this stage happiness rises sharply, a result of many factors, including:
• Financial security.
• Enhanced ability to control emotions and find solutions to conflict.
• Better at accepting misfortune.
• Less prone to anger and less inclined to pass judgment.
• A live-for-the-present attitude as a result of a limited lifespan, i.e. a determination to make the
best of the remaining years.
• Acceptance of strengths and weaknesses.
• The absence of ambition and competition for position.
• Grandchildren, without the responsibility of good parenting.
As a result of these factors, stress and worry give way to general cheerfulness and happiness. This more
than compensates for the physical disadvantages that accompany old age referred to above. The net result
is more productive older people, just at the time when they leave the work force.
Is the average person able to buck the trend? The answer is no, but it is possible to alleviate stress and
worry in middle-age by being aware of the life-cycle of happiness and its contributing factors. Stress
and worry management is key, and sufficient sleep, regular exercise, adequate saving and sound money
management are parts of the key.
1.9 The life-cycle and investing
As we said upfront, the above exposition is of little use if one does not have investments. Only a small
percentage of people (some studies say 6–10%) reach their financial security goal (FSG), and are able to
replace formal work with other activities.
Achieving your FSG at an appropriate age (i.e. whenever you wish to) is in your hands. The rules to
be followed in the four phases of life are straightforward, but the majority of individual do not follow
them. The reason is to be found in behavioural finance: people are innately optimistic, meaning that they
subconsciously believe that will “somehow” achieve their FSG. The reality is that one has to consciously
plan one’s financial future. There are many hurdles (such as peer pressure and ill health) to achieving
one’s FSG, and these must be in one’s consciousness and managed.
There is much pleasure in achievement, especially the achievement of one’s FSG, and there is much
unhappiness resulting from having to rely on one’s children or the state for food and shelter. In general
there are three assumptions to happiness in one’s advanced-age period:
• Financial health.
• Physical health.
• One’s children must be on the success treadmill (for this reason their education is paramount).

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The financial system
2 The financial system
2.1 Learning outcomes
After studying this text the learner should / should be able to:
• Elucidate the categories of investments.
• Describe the six elements that make up the financial system.
• Describe the financial instruments / investments in a broad sense.
• Know of the existence of the allied non-principal participants in the financial system.
2.2 Introduction
This section on “The financial system” follows the section “Four phases of the life-cycle” and precedes
the sections:
• Investment instruments.
• Investment principles.

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The financial system
The reason for this stand-alone main section is that 70–80% of most portfolios are comprised of financial
assets, i.e. these assets are delivered by the financial system. As will be seen, the majority of financial
assets held are shares. The reason is simple: return, compared with other asset classes.
One of the reasons for the general disinterest in investments, which leads to the majority not achieving
their FSG, is that potential investors are confronted with a maze of terms relating to investments: hedge
funds, alternative investments, money market investments, investment policies, bills, bonds, notes, ETFs,
SUTs, PUTs, real assets, shares / stocks / equities, fixed-income / fixed-term assets, derivatives, collective
investment schemes, and so on and so forth. Most people are confused by these examples of terminology
and feel intimidated by the subject matter.
The confusing terminology will be demystified as we progress in this text. The first step is to outline the
categories and subcategories of the ultimate investments. By ultimate is meant the actual investments that
exist, i.e. investors invest in these either directly or indirectly via financial intermediaries. The ultimate
investments are straightforward:
• Financial investment instruments:
-- Debt instruments.
-- Share (aka stock and equity) instruments.
• Real investments:
-- Property (aka real estate).
-- Commodities.
-- Other real investments (art, rare coins, antique furniture, etc.).
As will be seen in more detail later, financial investments are issued by ultimate borrowers. It will also be
seen that financial intermediaries exist to facilitate financing in various forms. There are various types
and they all hold ultimate investments and issue indirect investments, such as deposits and participation
units (or interests), in order to finance the holding of the ultimate investment instruments. There are
three categories of financial intermediaries and they issue indirect securities as indicated:
• Banks: deposit instruments (certificates).
• Quasi-financial intermediaries (QFIs): debt instruments.
• Investment vehicles: participation interests (PIs).

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The financial system
In summary, we have the following investments:
• Ultimate investments:
-- Financial investments instruments (issued by ultimate borrowers):
• Debt instruments.
• Share (aka stock and equity) instruments.
-- Real investments:
• Property (also called real estate).
• Commodities.
• Other real investments (art, rare coins, antique furniture, etc.).
• Indirect investment instruments (issued by financial intermediaries):
-- Issued by banks: deposit instruments.
-- Issued by quasi-financial intermediaries: debt instruments.
-- Issued by investment vehicles: participation interests.
As we will see below, the ultimate lenders hold the ultimate investment instruments directly or indirectly
via financial intermediaries. Also, some financial intermediaries hold the financial liabilities of other
financial intermediaries. In what follows, keep in mind that we use the terms investments and assets
interchangeably, and that these terms apply to financial and real assets. The terms instruments and
securities apply to financial assets only. Keep in mind also that asset means “I own”, and that financial
assets are the financial obligations / liabilities (liability = “I owe”) of ultimate borrowers and financial
intermediaries, which may also be termed financial claims on borrowers.
The above may be a little confusing to those unfamiliar with the financial system and investments. These
terms will be well understood as we progress in this text.
Generally speaking investment portfolios do not contain a large proportion of real investments. The
reason is that real investments do not generate returns in the form of regular cash flows (the exception
is one section of the property market = rental properties). Financial investments, on the other hand,
generate interest and dividend income. All investments generate capital gains (small, though, in the case
of the money market).
For these reasons, the majority of large portfolios (such as retirement funds) are comprised of financial
assets – to the extent of around 90%. Individuals’ portfolios generally have a smaller proportion of
financial assets, mainly because of the need to have a dwelling (property). Because of the dominance of
financial assets in portfolios, we need to spend some time on the system that delivers financial assets:
the financial system.

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The financial system
2.3 Six elements of the financial system
The financial system is primarily concerned with borrowing (issuing of debt and share securities) and
lending and may be depicted simply as in Figure 1.
Securities
FINANCIAL
INTERMEDIARIES
Securities
Indirect investment / financing
Securities
Direct investment / financing
Figure 1: financial system (simplified)
ULTIMATE
BORROWERS
(deficit economic
units)
Surplus funds
Surplus funds Surplus funds
ULTIMATE
LENDERS
(surplus economic
units)
Figure 1: financial system (simplified)
The financial system has six essential elements:
• First: the ultimate lenders (= surplus economic units) and borrowers (= deficit economic units),
i.e. the non-financial economic units that undertake the lending and borrowing process. The
ultimate lenders lend to borrowers either directly or indirectly via financial intermediaries, by
buying the securities they issue.
• Second: the financial intermediaries which intermediate the lending and borrowing process.
They interpose themselves between the lenders and borrowers, and earn a margin for the
benefits of intermediation (including lower risk for the lender). They buy the securities of the
borrowers and issue their own to fund these (and thereby become intermediaries).
• Third: financial instruments (or assets), which are created/issued by the ultimate borrowers and
financial intermediaries to satisfy the financial requirements of the various participants. These
instrumentsmaybemarketable(e.g.treasurybills)ornon-marketable(e.g.retirementannuities).
• Fourth: the creation of money (= bank deposits) by banks when they satisfy the demand for
new bank credit. This is a unique feature of banks. Central banks have the tools to curb money
growth.
• Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the
issue and trading (dealing) of the financial instruments.
• Sixth: price discovery, i.e. the establishment in the financial markets of the price of money,
i.e. the rates of interest on debt (and deposit) instruments and the prices of share instruments.
Each of these is given attention below.

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The financial system
The same non-financial economic sectors appear on the other side of the financial system as ultimate
lenders. The members of the four sectors are either lenders or borrowers or both at the same time. An
example of the latter is government: the governments of most countries are permanent borrowers (usually
long-term), while at the same time having short-term funds in their accounts at the central bank (and
the private banks in some cases), pending spending. As noted before, borrowing and lending takes place
either directly or indirectly via the financial intermediaries.
2.5 Element 2: financial intermediaries
Financial intermediaries exist because there is a conflict between lenders and borrowers in terms of their
financial requirements (term, risk, volume, etc.). For example, members of the household sector as lenders
generally have a need for current account deposits (i.e. essentially 1-day deposits), while government’s
borrowing needs range from 3 months to 30 years. Another example: a surplus company may wish to
lend for 3 months, while a deficit company may wish to borrow for 2 years.
The financial intermediaries solve these divergent requirements by (for example) investing in the
instruments of debt of government with the short-term funds of the household sector invested with
them. They also perform many other functions such as lessening of risk for lenders, creating a payments
system, the efficacy of monetary policy, and so on.

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The financial system
MAINSTREAM FINANCIAL INTERMEDIARIES
DEPOSIT INTERMEDIARIES
Central bank
Private sector banks
NON-DEPOSIT INTERMEDIARIES
Contractual intermediaries (CIs)
Short-term insurers
Long-term insurers
Retirement funds
Collective investment schemes (CISs)
Securities unit trusts (SUTs)
Property unit trusts (PUTs)
Exchange traded funds (ETFs)
Alternative investments (AIs)
Hedge funds (HFs)
Private equity funds (PEFs)
QUASI-FINANCIAL INTERMEDIARIES (QFIs)
Securitisation / special purpose vehicles (SPVs)
Development Finance Intermediaries (DFIs)
Investment trusts / companies
Finance companies
Savings and credit cooperatives
Micro lenders
Buying associations
Table 1: Financial intermediaries
Financial intermediaries may be classified in many ways. A list of the financial intermediaries that are
found in most countries, according to our categorisation preference, is as shown in Table 1. There are
twobroadcategories:mainstreamfinancialintermediariesandquasi-financialintermediaries.Theformer
are straightforward: they have financial liabilities and assets (with the exception of PUTs), while the
latter border on being financial intermediaries. A good example is the SPV (special purpose vehicle);
it generally is created for a specific purpose (usually a specific activity such as securitising mortgages),
and after this transaction is completed it is closed to further business.

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The financial system
LENDERS BORROWERS
BUYERS SELLERSthe difference
the difference
Figure 5: primary & secondary markets
Primary market
Secondary market
money
securities
money
securities
Figure 5: Primary and secondary markets
2.7.2 OTC and exchange-driven markets
Secondary financial markets evolved to satisfy the needs of lenders (investors) to buy and sell (exchange)
securities when the need arises. Some markets naturally exist in a safe (i.e. low risk) environment, while
for others a safe environment has been created. The former markets are called over-the-counter (OTC)
markets, and the latter the formalised (or exchange-driven) markets.
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The financial system
By and large, the foreign exchange and money markets of the world are OTC markets, and they essentially
are the domain of the well-capitalised banks, while the share and bond23
markets are exchange-driven
markets. Derivative instruments fall under both categories.
2.7.3 Debt market
The debt market is the market in which debt instruments are issued and exchanged for funds. Interest is
paidondebtinstruments(hencetheothername:interest-bearingmarket),asopposedtodividendsthatare
paid on shares. The debt markets are also called the fixed-interest markets, but this is a misnomer because
interest may be floating, i.e. reset during the life of the instruments. The debt market is comprised of:
• Short-term debt market (STDM, which is a major part of the money market, the other part
being deposits).
• Long-term debt market (LTDM, the marketable part of which is called the bond market).
The dividing line between the STDM (money market) and the LTDM is determined according to the term
to maturity of the debt instruments, and is arbitrarily set at one year. Thus, the STDM (money market)
is defined as the market for the issue and trading of securities with maturities of less than one year, and
the LTDM as the market for the issue and trading of securities with maturities of longer than one year.
The securities referred to are marketable (e.g. a treasury bill and bond) or non-marketable (e.g. a non-
negotiable certificate of deposit – NNCD – of a bank), and the markets are wholesale markets (i.e. large
denomination securities) or retail markets (i.e. small denomination securities). In this respect the money
market differs from the bond market.
Thus the money market is the entire STDM (plus the deposit market) and can be defined as follows:
The primary market for the issue of short-term retail and wholesale securities, and the secondary
market for the trading of short-term wholesale marketable securities.
The definition of the bond market is:
The primary market for the issue, and the secondary market for the trading, of long-term wholesale
marketable securities.
The reason for including retail and non-marketable securities in the definition of the money market is
that the retail money market is as large as the wholesale money market, and that it also encompasses
large markets such as the call money (i.e. on-day term) deposit markets (which do not have secondary
markets).Italsoincludesthesignificantinterbankmarket,whichencompassesthebank-tobankinterbank
market, the short-term lending operations of the central bank to the banks at the repo rate for monetary
policy purposes, and the reserve requirement (bank deposits with the central bank).

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This detail on the money market is mentioned here because of the critical importance of money creation
and monetary policy which play out in the money market. Also, money market rates, as we shall see,
form the foundation of all other financial markets. The money market is depicted in Figure 6 and the
bond market in Figure 7.
2.7.4 Share market
The share market (also called stock market and equity market) is the market for the issue and trading
of shares. As we have seen, there are two varieties of shares:
• Ordinary shares, the outstanding amount of which makes up the permanent capital of a
company, because this instrument has no maturity date.
• Preference shares, the outstanding amount of which makes up the long-term capital of a
company, because this instrument usually has a maturity date, i.e. is redeemable.24
The share market and the long-term debt market (of which the bond market is a part) together are often
referred to as the capital market, because these markets provide for the long-term capital needs of the
corporate sector (and government – bonds only in this case). The share market is depicted in Figure 8.
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INVESTMENT
VEHICLES
CIs
CISs
AIs
CENTRAL
BANK
BANKS
• Shares (domestic)
• Shares
• Shares
QFIs:
DFIs, SPVs,
Finance
Co’s, etc
Figure 8: share market
• Share (foreign)
• Shares
ULTIMATE
BORROWERS
(deficit economic
units)
HOUSEHOLD
SECTOR
CORPORATE
SECTOR
GOVERNMENT
SECTOR
FOREIGN
SECTOR
ULTIMATE
LENDERS
(surplus economic
units)
HOUSEHOLD
SECTOR
CORPORATE
SECTOR
GOVERNMENT
SECTOR
FOREIGN
SECTOR
Figure 8: share market
Ordinary shares are permanent capital also in the sense that they represent a share in the ownership
of a company (meaning they don’t actually represent borrowing – but we, for the sake of simplicity,
regard them as representing borrowing). Preference shares are named as such because, in the event of
the liquidation of the company, they enjoy preference over ordinary shares [and creditors (e.g. bond
holders) enjoy preference over preference shares], in terms of ownership of the assets of the company.
2.7.5 Foreign exchange market
The foreign exchange (forex) market is the market for the exchange of one currency (e.g. corona or
LCC25
) for another (e.g. US dollar or USD). An example of an exchange rate is USD / LCC 7.35. Almost
all currencies are referenced against the USD (for the sake of convenience), and in an exchange rate the
USD is the base or vehicle currency (= 1 unit) and the other is the variable currency (= number of units
per 1 USD).
The exchange of one currency for another is effected in central bank notes at bureaux de change or in
bank deposits (which is why the forex market is often termed the international money market). The latter
is the wholesale forex market, and the former the retail forex market, and the latter dwarfs the former.
Box 1: LC exporter (LCC millions)
Assets Liabilities
Goods (exported)
US bank deposit (USD 10) (earns)
US bank deposit (USD 10) (sells in fx mkt)
LC bank deposit (receives)
-100
+100
-100
+100
Total change 0

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An example will make this clear (see boxes 1–6; assumption USD / LCC 10.0). A Local Country (LC)
exporter sells goods to a US importer and is paid USD 10 million by a deposit in its name at a US bank.
At the same time a LC importer receives goods from a US exporter and needs to pay the US exporter
USD 10 million. The LC exporter sells the USD 10 million deposit in the forex market (made by the
large banks) in exchange for LCC 100 million, while the LC importer buys USD 10 million in the forex
market, and pays LCC 100 million for the USD 10 million. He then pays the US exporter USD 10 million.
In this example the supply of and the demand for forex are equal, and the exchange rate will not have
changed. There are other sources of supply and demand. You will recall from our depiction of the financial
system shown earlier that one of the four sectors that make up the ultimate lenders and borrowers is
the foreign sector. This is where the other part of the forex market fits in. The foreign sector is able to
supply funds to LC, domestic institutions are able to lend to the foreign sector, and the foreign sector is
able to borrow funds in the local market (i.e. issue securities in the local market).
Thus the forex market, essentially (it is more complex, but this is the essence), is made up of the:
• supply of forex forthcoming from:
-- foreign lenders (as depicted) (i.e. foreign investors),
-- local institutions borrowing offshore, and
-- exporters, and the
• demand for forex forthcoming from:
-- foreign borrowers issuing foreign securities locally,
-- local institutions lending / investing offshore, and
-- importers.
Thus, it will be apparent that in order for a forex market to function there needs to be a demand for and
a supply of forex. Demand is the demand for, say, USD, the counterpart of which is the supply of LCC.
This cannot be satisfied without a supply of USD, the counterpart of which is a demand for LCC. The forex
market brings these demanders and suppliers together, and the exchange rates of the LCC against foreign
currencies (the USD and others via the cross rates), is the outcome of these forces of supply and demand.

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Figure 12: derivative
OPTIONS
OTHER
(weather,
credit, etc)FUTURES
FORWARDS SWAPS
Options
on swaps =
swaptions
Options
on
futures
Forwards / futures
on swaps
Figure 12: derivative instruments / markets
instruments / markets
The derivative markets are mentioned here for the sake of completeness and also because two of the
group, futures and options, can be used, and are used, as substitutes for the instruments of debt and
shares. We will return to this issue.
2.8 Element 5: money creation
Money creation is an integral part of the financial system, and a significant part of the investment
environment in terms of new financial instrument (debt) creation, inflation and interest rates. Interest
rates are important for many reasons, including being a target / reflection of monetary policy actions
and the valuation of financial instrument (debt and shares) and income-property assets.
Money is anything that is generally accepted as a means of payment. In the distant past money has been
many different objects, but stuck in our financial psyches are gold and silver coins. Today, money has
two components:
• central bank notes and coins (N&C) and
• bank deposits (BD)
held by the local non-bank private sector (NBPS). The outstanding amount of these (measured monthly
in most countries) is therefore the amount of money in circulation (AMIC or just M, also called the
money stock26
). There are many different measures of money; for the sake of simplicity we use M3, which
encompasses all deposits of the NBPS plus its holdings of notes and coins (but from hereon we call it M):
M = N&C + BD of the NBPS.
One of the oldest theories in economics is the quantity theory of money of Irving Fisher. In slightly
amended form it can be expressed as:
∆M × ∆V = ∆P × ∆RGPD

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where ∆ denotes change over a period, M = money, V = velocity of circulation of M, P = price level,
RGDP = GDP in real terms (i.e. after adjusting for P). It will also be evident that P × RGDP = nominal
GDP (NGDP).
Given that V is stable in the long-term, ∆M translates approximately into ∆RGDP and ∆P. In a particular
country27
, for example, over the past 40 years (roughly):
∆M = + 14%
= ∆P (9%) + ∆RGPD (5%).
It is argued that an increase in RGDP cannot take place without an increase in M, and that if M growth is
higher than the economy’s ability to adjust to the increased demand underlying the change in M, inflation
results and growth suffers. In other words, if the growth rate in M is kept to a level consistent with the
economy’s ability to adjust to the increased demand for goods and services, growth will increase with
little impact on P. Thus, monetary policy endeavours to “control” the increase in M to a level consistent
with the economy’s ability to accommodate increased demand.
What makes up GDP? It is:
C + I = GDE
GDE + X – M = GDP (expenditure on)
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where C = consumption expenditure of the private and government sectors, I = investment of the private
and government sectors, X = exports, I = imports. It may also be seen as follows:
C + I = GDE = domestic expenditure = domestic demand.
X – M = trade account balance (TAB) = net foreign demand.
In many countries C + I = about 70–80% of GDP. How does this fit with money creation? It fits with
how money is created. New money = a new bank deposit held by the NBPS (we’ll ignore N&C because
it is a minor part of M), is created by a bank making a new loan to the NBPS or government. Allow us
to present an example.
Company B borrows LCC100 million from a bank through the issue to it of LCC100 million securities
(debt instruments such as bonds) with the purpose of purchasing LCC100 million goods from Company
L. The bank credits Company B’s current account with LCC100 million and Company B pays Company
L LCC100 million by internet transfer (i.e. electronic funds transfer – EFT). Company L thus becomes
a surplus economic unit (new bank deposit), while Company B becomes a deficit economic unit (bank
loan via the issue of bonds to the bank).
BORROWERS
(LCC MILLIONS)
BANKS (ZAR MILLIONS)
Goods -100
CO LCO B
Goods +100
Bonds +100 DepositsDeposits +100Bonds
BSCoC = credit M3 Money creation identity
LiabilitiesAssets
Total +100 Total +100
+100
LiabilitiesAssets
Total +100 Total +100
+100
LiabilitiesAssets
Total 0 Total 0
LENDERS
(LCC MILLIONS)
Figure 13: money creation
Figure 13: money creation
As shown in Figure 13, the banking sector has a new asset (+LCC100 million bonds of Company B = a
new loan) and a new deposit liability (+LCC100 million deposits of Company L = new money). Thus,
M has increased by LCC100 million and the balance sheet cause of change (BSCoC) in M is the loan by
the bank (in the form of the purchase of new bonds issued by Company B and purchased by it). The
purchase by the bank of bonds is new credit (loan) creation.
Money was created by balance sheet entries, but, and this is crucial knowledge, underlying it was a
“demand” for bank credit (loan), and underlying the demand for credit was an economic activity = a
demand for goods / services. If the “goods” are a new factory to be built, investment (I) increases; if the
“goods” are consumption goods, C increases. It was made possible by money creation.28

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Inthelightofthisrevelation,whatismonetarypolicy?ItisaboutcontrollingthegrowthrateinMcreation.
As we saw, underlying money creation is the increased demand for goods and services (∆C + I). How
does the central bank (CB) do this? It implements monetary policy by creating a permanent liquidity
shortage (LS). This means that it forces, via open market operations (OMO), the banks to borrow from
it on an overnight but permanent basis an amount of money (called reserves – R) at the CB’s Key Interest
Rate (KIR) (also called repo rate, basis rate, discount rate, and so on). This KIR directly influences the
interbank lending rate, the call deposit and other deposit rates of the banks, and, via the bank margin
(the margin that the banks endeavour to earn between what they pay for deposits and what they earn on
assets = credit extended), bank lending rates. The bank lending rate best known is the prime rate (PR); it
is a benchmark rate, i.e. some borrowers will pay, for example, PR – 2% while others will pay PR + 1%.
0
5
10
15
20
25
30
KIR
Prime rate
Figure 14: KIR & prime rate (month-ends over 50 years)
Figure 14: KIR & prime rate (month-ends over 50 years)
The ultimate aim of the policy is to influence the growth rate in bank lending, i.e. the demand for credit.
As you now know, additional bank lending is the counterpart of money growth and underlying bank
credit growth is increased demand for goods and services (∆C + I). It will be evident that purpose is
to harmonise the additional demand for goods and services with the economy’s ability to satisfy the
additional demand.
Figure 14 shows the relationship between the banks’ PR and the KIR over a period of almost 50 years
for a particular country. It will be seen that in this case a change in the KIR is immediate translated into
an equal change in PR. This can only be achieved if the CB has control over bank liquidity, and makes
the KIR effective by engineering a permanent LS.

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2.9 Element 6: price discovery
The prices of debt (= interest rates, from which prices are derived) and shares (= prices, influenced
by interest rates) are discovered in the financial markets, by the interplay of demand and supply. Or
are they – when the supply of credit is unlimited (in the sense that credit is supplied if the individual
borrower is creditworthy or the corporate project is viable)?
Given such a monetary system, it is evident that a referee (a CB) is required and that interest rates cannot
be “free to find their own levels”. The reason is clear: because the CB uses interest rates to influence the
growth rate in the demand for loans / credit and therefore in M. Thus, the CB in essence “sets” the lower
point of the yield curve29
(see Figure 14) and this point becomes the reference point for all interest rates.
Even rates for 20 to 30-year investments are affected by the short-term rates.

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Figure 14: short-term banking rates & yield curve for
Interest
rate / ytm
(%)
1 day
Term to maturity
20 years10 years
Figure 14: short-term banking rates & yield curve for government securities
One-day
nominal rfr
Risk-free rates (marketable
government securities)
Call deposit rate – large deposits
Central bank repo rate
Bank prime lending rate
Interbank loan rate
Call deposit rate – small depositors
government securities
A yield curve is a snapshot” of interest rates and is differentiated from a time series of interest rates,
which is a specific rate/s / prices over a period of time. Figure 15 is an example of the latter [in this case
rates (ytm) over a period of 50 years].
Interest rates are also a major input into the valuation of shares as we shall see later. While interest rates
and share prices are fundamentally tied to the KIR, in the share market the outcome of supply and
demand (share prices) can be different, and substantially so, from the fair value prices (FVP) dictated
by interest rates and company profits. This vital issue later is taken further later.
2.10 Allied participants in the financial system
From the above discussion it will be evident that there are a number of allied participants on the financial
system. By this we mean participants other than the principals (those who have financial liabilities or
assets or both). As we now know, the principals are:
• Lenders.
• Borrowers.
• Financial intermediaries.

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If you buy this bond you will be paid interest pa of LCC 10 000 (= 10% pa on LCC 100 000), irrespective
of the rate at which the bond trades in the secondary market after issue. Just like in the case of shares,
bonds are bought and sold and price (rate) discovery takes place in the secondary market which is a
function of supply and demand [and of course the central bank’s (CB’s) key interest rate (KIR) which
determines the start of the yield curve]. Two issues need to be elaborated upon here:
• The term rate of interest does not apply in the case of bonds. Rather, because of multiple cash
flows in the future (all are FVs), the secondary market rate that applies here is an average rate
earned over the life of the bond, which is called the yield to maturity (ytm).
• It will be evident that if you buy the bond at an ytm of 10% pa (which equals the coupon of
10% pa, the price of the bond will be 1.0 (i.e. you will pay LCC 100 000 for it). However, if
you sell the bond in the secondary market at an ytm lower than the coupon rate (remember it
is fixed), then the price of the bond will be higher than 1.0, and you will make a capital gain.
Conversely, if you sell the bond are an ytm higher than the coupon rate, the price will be lower
than 1.0, and you will make a capital loss.
In this way, bonds are similar to shares. The holding period return (HPR) on a PVB over a will be (P0
=
purchase price of bond; P1
= selling price of bond):
HPR = (P1
– P0
) × nominal value of bond.
Any coupon income is incorporated in the valuation formula, as we will see later.
BOX 2: EXAMPLE OF PLAIN VANILLA BOND

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3.6 Share market instruments
As we saw earlier there are two types of shares:
• Ordinary shares.
• Preference shares.
The latter are similar to PVBs in that they have a fixed maturity date (in most cases), a nominal / face
value and a coupon (called a dividend). As these instruments are only available in large-denominations
only the high net worth (HNW) members of the household sector invest in them (and in fact only a
few of them).
Ordinary shares, on the other hand, are the bread of investors, small and large. The small investor may
either hold shares directly or via investment vehicles (covered later).
An example of a share is presented in Box 3. The company had a share capital of £ 200 000 and each
share had a nominal value of £ 1.0, meaning there were 200 000 shares issued. Thus, when the company
was formed and its shares were subscribed for, its balance sheet presented as indicated in Box 4.
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BOX 3: EXAMPLE OF ORDINARY SHARE
BOX 4: INITIAL BALANCE SHEET OF
BLAAUWBANK UNITED GOLD MINING COMPANY LIMITED (£)
Assets Capital and liabilities
Bank deposit 200 000 Share capital 200 000
If the company invested its cash assets (= bank deposit) in a sound mining venture and made say a £ 40 000
after-tax profit the first year, and paid out dividends of half this, i.e. £ 20 000, each shareholder would
receive a dividend of £ 0.10 per share (assume 100 pence per £) (£ 20 000 / £ 200 000). Mr de Villiers,
the holder of the share certificate in Box 3, i.e. the holder of /investor in 100 shares, would have received
a dividend of £ 10 (£ 0.1 × 100 shares). This equals a return of 10% over the period the shares were held
(£ 10 / £ 100 × 100).
As we know, shares trade in the secondary market where price discovery takes place, and capital gains
and losses can be made. Assuming the “market” (i.e. investors in general) reacted positively to the
performance of the company and the dividend paid [= a dividend yield of 10% (£ 20 000 / £ 200 000 ×
100)], the share price would have risen. If the “market” was expecting the share market norm for mining
companies of a dividend yield of 5%, the share price could have risen to £ 2 per share. For new investors,
the new share price delivers, based on the “historical dividend paid” (HDP), a dividend yield (DY) of 5%:
DY = HDP per share / share price × 100
= £ 0.1 / £ 2 × 100
= 5%.

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You will buy the future because you believe on date T+0 that the price of BUGMIC shares will be higher
than £ 2.20 on T+180. If you are right, and the price on T+180 is £ 2.50 per share, you will take delivery
of 1 000 BUGMIC shares on T+180 and pay £ 2.20 per share for them. You will then be able to sell them
at the market price of £ 2.50 per share, and make a £ 0.30 profit per share, i.e. a £ 300 profit (£ 0.3 ×
1 000). You get the margin back plus interest.
The principle will be clear: you have a choice of buying the futures contract or borrowing funds at the
going interest rate for 180 days and buying the shares outright. In other words, the FVP of the futures
contract will be equal to the spot price of the share, escalated by the rate of interest of 180 days, less any
dividends. If it is not, arbitrage opportunities exist. If it is, then it makes no difference to you to buy the
future on BUGMIC shares or the shares themselves. We will return to this.
Another example of a futures deal is presented in Figure 8. It is self-explanatory. Note that the 90-day
futures contract was sold and bought via the exchange at LCC 1 100, when the spot price was LCC 1 000.
The latter is important for determining the futures contract price (discussed later), but becomes irrelevant
once the deal is done. The wheat is delivered at LCC 1 100 on T + 90 (in this example when the spot
price is much higher – see chart in Figure 8). The deal gave both parties price-certainty, but the flour
miller gets the better deal (with hindsight).
Flourmiller
Sells 100
futures
contracts
Buys 100
futures
contracts
Broker-
dealer
(member of
Exchange)
Exchange
Exchange
buys 100
futures
contracts
Exchange
sells 100
futures
contracts
T + 0 T + 90 days
Spot price
Futures price
Price of
wheat
per ton
Time
LCC1000
LCC1100
On T + 0
• Has long position
• Will have a harvestin 90 days = 100 tons
• Expectsprices to fall
On T + 0
• Has shortposition
• Requires wheatin 90 days = 100 tons
• Expectsprices to rise
Spot price
1 wheat futures
contract = 1 ton
Wheatfarmer
Figure 8: example of futures contract
Broker-
dealer
(member of
Exchange)
Figure 8: example of future contratct
Options are similar to futures, the difference being that you have the option (not the obligation) to buy
(call option) or sell (put option) the shares between now (T+0) and expiry of the option contract (T+90).
You will only exercise the option if it pays you to do so. You pay a price (called a premium as in the case
of an insurance contract) for this right to buy or sell at a price determined on T+0.
Futures and options contracts are written on most of the instruments covered here, and retail-sized
futures and options are also found in many markets. In many countries individuals can buy / sell futures
and options on all the main currencies and many of the shares.

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3.8 Real investments
3.8.1 Introduction
As we have seen, real investments are usually categorised into:
• Property.
• Commodities.
• Other (art, antiques, rare coins, rare stamps, etc.).
There are of course many subcategories to be found under each (see below). Real investments have many
characteristics that differentiate them from financial assets such as:
• Zero recurring return (with exception of commercial property).
• Inflation hedge.
• Inefficient (illiquid) markets.
• High transactions costs.
• Insurance and storage (in the case of commodities and “other”).
• High price volatility.
• Tangibility and pleasure (art, rare books, antiques).
3.8.2 Property Oftherealinvestments,propertyisthemostsignificantinvestmentfortheretailinvestor
(individual), and it usually makes up a large percentage of the portfolio (when young – because the
individual is obliged to have this asset). However, in the case of wholesale investors such as retirement
funds, property makes up a small proportion of assets (in most countries around 3–5%).
There are many forms of property investment:
• Undeveloped land (zoned residential, industrial, office, etc.).
• Developed farm (fruit, cattle, game, etc).
• Residential (home).
• Multi-residential (block of flats).
• Retail (shopping centre, sectional title retail outlet).
• Office building.
• An office (sectional title).
• Industrial building.
• Leisure and tourism (hotel, resort, golf course, theme park).32

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Generally speaking investment portfolios do not contain a large proportion of commodities. The reason,
as noted, is that commodities do not produce an income34
. Also, it is rare that commodity portfolios
contain consumable products35
. Where investment portfolios contain commodities, the commodities are
usually of the precious metal variety, particularly gold, platinum, silver and so on.
Precious metal investments take on many forms such as bullion, but the norm is coins, because of the
convenience (compared with bullion). As noted, commodities do not yield a recurring return, only capital
gains. Precious metals are also notably volatile at times; gold, for example, is a popular investment in
time of unrest and uncertainty.
Often, investment in commodities takes the form of investment in investment vehicles, such as securities
unit trusts (SUTs) and exchange traded funds (ETFs) (to be discussed later), mining shares and so on.
3.8.4 Other real investments
“Other real investments”, as we have briefly seen, include investments in items such as:
• Art of masters (such as Rembrandt).
• Antique furniture.
• Rare stamps.
• Rare books.
• Rare coins.
Generally speaking, investments in these items, and in certain commodities (such as gold and diamonds),
are not undertaken by the large investors such as retirement funds, but by high net worth individuals
and reflect motivations such as:
• The desire for diversification of personal investments.
• Personal satisfaction (aesthetic value).
• Survival (as in times of war).
• Inflation hedging.
To this category one can add other investments that do not have an aesthetic value, such as “tank
containers”. These investments have currency hedging and tax advantages
Generally,investorsexpectcapitalgainsfromallrealassets,andareturnonlyoncertainnon-undeveloped
propertiesintheformofregularrentalincome.Manyindividualinvestorsregardtheirresidentialproperty
as their sole investment in real assets, because it generally makes up a large proportion of their assets.

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The financial system is again presented in Figure 9. The securities issued by the three investment vehicle
categories (which we call participation interests – PIs) are highlighted, as well as the household sector
(as the main lenders) which is our interest here. The institutions under each category are:
• Contractual intermediaries (CIs):
-- Long-term insurers (LTIs).
-- Retirement funds (RFs).
• Collective investment schemes (CISs):
-- Securities unit trusts (SUTs).
-- Property unit trusts (PUTs).
-- Exchange traded funds (ETFs).
• Alternative investments (AIs):
-- Private equity funds (PEFs).
-- Hedge funds (HFs).
As can be seen, the investment vehicles jointly are holders of the securities issued by the ultimate
borrowers and other financial intermediaries [debt (and deposits) and shares]. Not shown here is that
certain of the investment vehicles also hold certain real assets.
3.9.2 Long-term insurers
In most countries the statute covering life companies (long-term insurers / assurers) makes provision
for the following different classes of life business. The insurers are obliged to register under one or more
of these classes:
• Assistance
• Disability
• Fund
• Health
• Life
• Sinking fund
The products of these classes are called policies, for example, assistance policies, life policies, and so on.
Figure 10 illustrates the classes of business and indicates that the only products which can be regarded as
investment products are life insurance / assurance policies36
. Life policies are classified into two categories:
• Endowment policies.
• Annuity policies.

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3.9.3 Retirement funds
Retirement funds (RFs) are the best-known investment vehicles. By retirement, most individuals’ share of
the fund of which they are a member (called member’s interest, undivided share, participation interest)
represents their largest asset; usually the next largest asset in terms of value is their residential property.
Retirement funds are contractual savings institutions, and they are akin to savings plans. Persons employed
(the participants or members) and/or their employers contribute a certain amount of funds per time
period (usually monthly) to the fund. This usually takes place during the working lifetime of the members,
the purpose being to provide financially for retirement.
There are three types of retirement fund:
• Pension fund (also called defined benefit fund – rules of the fund provide for a specified benefit
at retirement).
• Provident fund (also called defined contribution fund – rules of the fund do not commit the
fund to a particular benefit; the company and the employee contribute a specified amount to
the fund).
• Preservation fund (a “parking” fund until retirement required by statute when a retirement
fund participant leaves employment).

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3.9.5 Property unit trusts
Property unit trusts (PUTs) are similar to SUTs in every respect except (mainly) in the nature of the
asset portfolio (property) and the fact that they are listed. The purpose of a PUT is to provide smaller
investors easy (i.e. small-amount) access to the property investment market, diversity in the property
investment market, and professional management of the portfolio.
3.9.6 Exchange traded funds
An exchange traded fund (ETF), also called a tracker fund, is a fund set up to track a particular index. It
is a type of investment company whose investment objective is to achieve the same return as a particular
market index. It invests in the securities of companies / government / commodities that are included in a
particular market index. This means that the fund has liabilities in the form of PIs (also called shares and
securities) which are listed on an exchange, and assets in the form of the specific shares / fixed-interest
securities / commodities that make up the relevant index according to their weightings in the index.
Figure 13: structure of an ETF
Figure 13: structure of an ETF
TRUST COMPANY
Assets Liabilities
Shares (can be
other securities)
that make up index
PIs
BORROWERS
Issue
securities
Funds
INVESTORS
Issue PI
securities
Funds
MANAGEMENT
COMPANY
Ultimately
responsible
for
TRUSTEES
Keep beady
eye on
operations
An investment in a share index ETF is an inexpensive way of gaining exposure to relevant segment of
the share market, i.e. exposure is gained without having to purchase the individual shares that make up
the index. Dividends are also payable to the holders of the shares of the ETF. The structure of an ETF
is shown in Figure 13.
It may be useful to present a few foreign definitions / explanations of ETFs; The US Securities and
Exchange Commission (SEC – the watchdog of the US securities industry) defines an ETF as:
“…a type of investment company whose investment objective is to achieve the same return as
a particular market index. An ETF is similar to an index fund in that it will primarily invest in
the securities of companies that are included in a selected market index. An ETF will invest in
either all of the securities or a representative sample of the securities included in the index. For
example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained
in the S&P 500 Composite Stock Price Index.”

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3.9.7 Private equity funds
Private equity fund (PEF) means a pool of funds that is available for investment in or are already invested
in unlisted companies. The motivation for the formation of PEFs is usually to provide funding for
entrepreneurial-type businesses that are highly regarded and to profit from the listing of these unlisted
companies at some stage in the future. This institution is mentioned here for the sake of completeness.
Individuals rarely invest in PEFs.
Private equity has become a separate asset class (some would say “becoming”), and in most countries
where private equity funds exist so do industry associations. Private equity is associated with venture
capitalinthatventurecapitalisseenasaformofprivateequity(start-upcapitalforthesmallercompanies).
In most (if not all) cases the industry associations include this term. For example, the South African
industry association is called the South African Venture Capital and Private Equity Association (SAVCA),
the European one is named European Private Equity and Venture Capital Association (EVCA), the Italian
one is called Italian Private Equity and Venture Capital Association (AIFI), and so on.
It should be evident that private equity funds are akin to investment companies on the liability side of
their balance sheets, whereas their assets are comprised of investments in non-listed companies only,
as opposed to investments in listed shares and other investments such as bonds and money market
instruments in the case of CISs.
3.9.8 Hedge funds
A hedge fund (HF) is akin to a pooled fund such a unit trust and a retirement fund in that it takes in
funds from investors and invests the funds on behalf of them in financial assets. However, it differs in that
it has: less of the statutory limitations of the other collective investment schemes (i.e. pooled funds), a
large relatively proportion of funds taken in is forthcoming from the management company and the fund
managers and, apart from being a “normal” investment vehicle (i.e. a “long only” investment vehicle), it
is able to:
• Use leverage (i.e. borrow funds – apart from the funds of investors).
• Go “short” of securities.
• Engage in derivative transactions.
This institution is mentioned here for the sake of completeness. Individuals rarely invest in HFs.

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3.10 Foreign investments
Foreign assets are comprised of the same asset classes as local assets. This is obvious because assets classes
are the same worldwide. The difference between the asset classes in smaller countries and those in the
larger economies is that the variety of assets in the larger economies is vast; in fact so vast that small
country fund managers tend, in their foreign asset class selection, to rely on the expertise of foreign
fund managers or invest in these markets via foreign investment vehicles.
There are many considerations in foreign investment selection, the most significant of which are currency
risk and the diversification opportunities: individual investors would be wise to spread their foreign
investments among a number of currencies in order to reduce risk
3.11 Asset classes
We have briefly covered all the investment assets that are available to investors. A summary is provided
in Figure 14 (showing that international asset groupings are the same as local assets groupings), and a
different perspective is presented in Figure 15. In the institutional investment industry, fund managers
refer to “asset classes”. They are as shown in Table 4.
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4 Investment principles
4.1 Learning outcomes
After studying this text the learner should / should be able to:
1. Distinguish the ultimate investments of the financial system and real economy and the
investment vehicles which intermediate them and the investors.
2. Define the objective of investment.
3. Explain the investment environment and the research levels.
4. Demonstrate an understanding of, and the relationship between, risk and return.
5. Appreciate the existence of investment theories and the lessons drawn from them that are
relevant to investments.
6. Describe the principle underlying the valuation of investments.
7. Explain the essence of portfolio management.
8. Describe asset class allocation of the course of the life-cycle.
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Money market
Held directly (with some exceptions):
• Treasury bills
• Commercial paper
• NCDs & NNCDs
Held in directly via Cis and CISs:
• As on left
Held directly:
• NNCDs
Hedge & private equity
funds
Held directly Not held
Real assets: Institutional investors: Individual investors:
Property
Held directly:
• Commercial buildings
Held indirectly:
• Mainly PUTs
Held in directly via CIs & CISs:
• As on left
Held directly
• Own residential property
• PUTs
Commodities
Held directly:
• Mainly precious metals
Held indirectly:
• Commodity ETFs
Held directly:
• Precious metals (coins)
• Cattle (in some countries)
Other real assets Not held
Held directly (by HNWI):
• Antique furniture
• Rare stamps and books
• Art, etc
Table 1: Asset classes of institutional investors & individual investors
This main section is concerned with the principles of investments. It is important to have a clear idea of
the objective of investment and to differentiate it from speculation and gambling. It is essential to have
an understanding of the context / environment of investments: the macroeconomy and its drivers, and
the substance of the four levels of research. It is essential to be cognisant of the risk inherent in most
investments and appreciate that there is a positive relationship between risk and return.
Because of the significance of investments to all individuals, many theories on and related to investments
have been proffered. While not all are of pragmatic employ, many of them extrude useful practical
lessons. An important principle is that financial and real asset markets discover prices which do not
necessarily align with fair value (given the level of risk-free and other interest rates); thus, it is important
to appreciate the principle underlying the valuation of investments. It is also important to understand
the essence of portfolio management.
These issues are addressed under the following headings:
• Definition and objective of investment.
• Risk-free rate.
• Investment environment.
• Risk and return.
• Investment theory: practical lessons.
• Valuation of investments.
• Portfolio management.

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4.3 Definition and objective of investment
The term investments refers to a portfolio of assets purchased with available funds that provides a return
in the form of periodic cash flows and/or a gain (or loss) in the amount of the original amount invested
(the capital). This tells us that there are two parts (either or both) to a return on an investment:
• a periodic cash flow
• a change in the value of the original investment (capital value), which may be positive or
negative.
Flowing from this, the objective of investment is to increase the amount of the original investment by:
• earning a periodic cash flow and/or
• earning a gain in the value of assets (making a capital gain).
Assets need to be managed. Fund / portfolio management is the practice of asset allocation, i.e. the
ongoing decision-making in respect of the allocation of funds between risky and non-risky assets, as
well as choosing specific assets within asset classes. It is a balance between risk and return. The asset
allocation function is based on in-depth asset market research.
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Investment is not gambling. Gambling is a game of chance in which the probability of loss (= risk) is
high. With investments the probability of loss can be small because there are methods of investment
management to reduce risk and enhance returns.
Investment is also not speculation. Speculation is investing own and/or borrowed funds for short-term
periods (often intra-day), and the probability of profit is substantially higher than with a gamble. This
is so because it is founded on research (technical and/or fundamental). However, the risk is lower than
in gambling and higher than in long-term investing.
4.4 Risk-free rate
The risk-free rate (rfr) is a concept that occupies centre-stage in investments / finance. It is a concept that
some scholars have difficulty in defining (some have even said that it does not exist). In our view there
is not one rfr, but a series stretching from the one-day treasury bill (TB) rate to the 30-year rate (ytm)
on government bonds; “it” is simply the rates on government securities (treasury bills and government
bonds), which are available daily (in efficient money and bond markets) and you can choose whichever
rate you require as a benchmark for an investment.
What does this mean? It means that the rfr is the lowest rate that can be earned with certainty, and that
you (when considering an investment for 5 years, for example) should regard the current 5-year bond
rate as the minimum return you are willing to accept. It follows that every non-government, i.e. risky,
investment should deliver a return [call it your required rate of return (rrr)] equal to the rfr plus a risk
premium (rp):
rrr = rfr + rp.
This simple formula should be the starting point when consideration is given to any investment.
What does risk-free mean? It means that if you purchase a government security, the rate at which it
is bought is certain to be earned, and this is because governments don’t default38
(since they have the
authority to borrow and tax in order to repay and service their debt).
Thus, there are two broad investment categories: risk-free and risky assets / investments39
. Risk-free assets
are government securities which deliver certain but lower returns. Risky assets are non-government
securities (shares, corporate bonds, property, etc.) which deliver uncertain but higher returns (depending
on the holding period). As we will show later, there is a positive relationship between return and risk.

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However, it is important to mention that risk-free assets are only credit-risk-free – as said, because
government has the power to tax and borrow funds. They are not market-risk-free if they are sold before
maturity. What does this mean? It means that the return is only certain if the asset is not traded in the
secondary market. Market prices are opposite to market rates, and if the market rate rises to a higher
level than the purchase rate, the price will be lower, and a capital loss will be made. However, this is
irrelevant in the sense that the rfr just acts as a benchmark return.
4.5 Investment environment
Market prices / rates are volatile and this is the chief risk faced in financial / real asset markets and this
takes place in the investment environment. Figure 2 illustrates the 3- and 10-year government bond
rates over a 50-year period in a particular country. Figure 3 illustrates the year-on-year changes in share
prices over the same period
What is the investment environment? The investment environment is the international economy and the
domestic economy, developments in which have an effect on the values (prices) of the assets of the asset
classes. It is well known that the prices of financial assets, particularly shares, can be extremely volatile
(see Figure 3), and this introduces the element of risk in financial markets. Investment risk is broadly
defined as volatility in asset prices and it is measured in these terms (see later).
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Ultimately, gross domestic product (GDP) growth is the major driver of asset prices, and asset price
changes (positive and negative) are often exacerbated by the irrational behaviour of participants in the
investment arena (known as the “herd instinct”). GDP is driven by gross domestic expenditure (GDE)
and the trade account balance (TAB). GDE is driven by the consumption expenditure (C) and investment
expenditure (I) of the private and government sectors, such that C + I = GDE. This is domestic demand.
Foreign demand for local products is reflected in exports (X) while imports (M) reflect domestic demand
for foreign goods. So, X – M = TAB = net foreign demand. The “big picture” (the entire economy) is
complete:
C + I = GDE
GDE + TAB = GDP (= the total of expenditure on GDP).
GDP is the total of net domestic production in a year, also called aggregate demand.
Interest rates are a significant factor in the economy (see Figure 4; period of over 50 years) and therefore
the financial markets: they are the counterpart of certain asset prices (debt assets) and a significant
input into the pricing of dividend-yielding shares (see Figure 5; period of over 50 years) and rent-
yielding property. Short term rates (the lower end of the yield curve), as we have seen, are under the
“control” of the central bank, the guardian of financial stability. They are the main instrument of central
bank monetary policy, and exert a powerful influence on the bank lending rates, and therefore on the
borrowing behaviour of the private sector, which drives money creation and GDP (see Figure 6; period
of over 50 years).
-10
-5
0
5
10
15
20
-10
-5
0
5
10
15
20
25
30
35
40
45
Figure 4: current GDE (yoy %) & real prime (adv 12 months)
gde (left)
real prime (right)
Figure 4: current GDE (yoy %) & real prime (adv 12 months)

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Underlying the BSCoC is a multitude of factors, including the actual demand for credit (DfC), interest
rates which affect the DfC, the state of the economy and expectations regarding it, etc.
Money creation ∆M+ is a critical factor in GDP growth (∆GDP) (Figure 6) and according to the adjusted
Fisher quantity theory of money (QTM) [V = velocity of circulation of money (generally a stable number);
R = real = adjusted for inflation (P)]:
∆M + ∆V = ∆P + ∆RGDP.
This significance embodied in the QTM is that money growth is an essential ingredient in GDP growth,
and that it is maximised if P is kept low (= a low and stable = predictable inflation environment) and
this can only be achieved if the change in the demand for goods and services (= the demand side of
GDP) (which underlies ∆M) is managed (inter alia by interest rates) at a level that can be satisfied by
supply (= the production side of GDP).

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So far we have touched upon almost all of the essential elements of the investment environment. To them
must be added the financial activities of government (= essentially the budget deficit), which results in
borrowing in the financial sector. There are two main sources of funds: the holders of investment money
[mainly the “institutions” (= retirement funds, insurers, SUTs and ETFs) and money creation by the
banks]. To the extent that the institutions’ funds are accessed, the government “crowds out” the private
sector, and to the extent that the banks buy government securities, money is created (∆M+).
Insummary,theessentialelementsoftheinvestmentenvironment=themacroeconomy,arethefollowing:
• ∆(C + I).
• ∆TAB [expanded into the current account of the balance of payments (CaBoP) which includes
other flows such as services payments/receipts, and its counterpart, the financial account of
the BoP, the FaBoP].
• ∆M.
• Budget deficit.
• Interest rates (dominated by the central bank in the money market).
Why are shares the most volatile of all asset classes? It is because companies take on more risk (versus
money market and bonds) in doing business (new projects, they are subject to the business cycle, etc.).
Higher risk (measured as higher volatility) equates with higher return in the long term. Therefore history
has generated data that demonstrates that shares have outperformed the other asset classes, and that the
asset classes have delivered returns in the following (descending) order:
• Shares (including hedge & private equity funds).
• Property.
• Bonds.
• Money market.
For this reason, shares are the most sought-after financial asset, making this asset class subject to intense
scrutiny (in the form of industry and company analysis), and susceptible to the herd instinct (captured
in the new discipline “behavioural finance”). These influences make shares highly volatile in terms of
price changes.
Figure 7 (period = over 50 years) presents the all share index together with GDE in year-on-year growth
terms. It will be clear that the share market generally anticipates GDE growth changes, and always
overreacts (up and down) to a substantial degree. It is notable that over the period, GDE and the all
share index growth rates were similar (1.1% per month). This indicates two main phenomena: the share
market is representative of the economy and the share market always reverts to its mean growth rate
(= GDE/GDP growth in nominal terms).

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-10
-5
0
5
10
15
20
25
30
35
40
45
-60
-40
-20
0
20
40
60
80
100
120
Figure 7: current GDE & all-share index (yoy)
All-share index (left scale)
GDE at current prices (right scale)
6 per. Mov. Avg. (All-share index (left scale))
6 per. Mov. Avg. (GDE at current prices (right
scale))
Figure 7: current GDE & all-share index (yoy)
Given asset price volatility, fund managers (or “investment houses”) and broker-dealers (who service the
fund managers) employ the services of investment analysts and specialist economists to anticipate future
asset price developments. The investment analysis process they undertake has four parts, as presented
in Figure 8.
It is a well know fact that asset class allocation is the most critical decision made in asset management.
It is responsible for a significant proportion of asset / portfolio performance (some analysts say up to
80%). Asset class allocation is critically based on macroeconomic (domestic and international) analysis.
In this regard we conclude with a relevant view of an asset manager41
:
“All investment decisions, particularly those relating to asset allocation, implicitly or explicitly rest on
someforward-lookingmacro-economicassumption.Anychangetothemacro-economicassumptionwill
inevitably influence the intrinsic or fair value of that investment or asset class. For example, a decision
to buy long-term government bonds is based on some assumption about future inflation; if the investor
assumed low future inflation and the outcome is high inflation, the value of such an investment would
turn out to be dramatically lower than anticipated.

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Figure 8: investments analysis: four steps
Domestic macroeconomic
research
International
macroeconomic
research
Industry analysis
(or sector analysis)
Security analysis
(or individual security analysis)
Figure 8: investment analysis: four steps
“One pillar of our investment philosophy is the recognition that the economic future could easily turn
out to be very different from the assumptions. Overconfidence in their ability to read the future is a
classic mistake made by investors. We guard against this risk by incorporating more than one economic
scenario into our investment strategy.
“We consider as wide a range of potential economic scenarios as possible. From these possibilities we
typically choose two or three scenarios that we believe cover a significant range of potential outcomes. In
this way we acknowledge and mitigate the risk attached to an uncertain, and often unpredictable, future.
“For each economic scenario we make assumptions about short and long-term interest rates, and about
economic growth and inflation, both locally and internationally. Using these economic assumptions as
our basic input, we estimate the intrinsic or fair value of each asset class that we explore.
“The scenarios have a strong international flavour. In a globalising world, with integrated financial
markets, we believe international influences will dominate over time. The scenarios are projected over
rolling five-year periods, a time frame typically used by most successful long-term investors.
“We attach probabilities to each scenario. The use of probabilities skews the macro-economic input
in the direction that we believe is the most likely outcome. This means that our investment strategy is
based on a core macro-economic view, although the element of future surprise is minimised through
the incorporation of various scenarios.

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“Another pillar of our philosophy is diversification across a range of asset classes. Diversification also
hedges our investment strategy against the potential for the future to surprise.”
The last mentioned, i.e. diversification, is one of the pillars of asset management; it is given some attention
in a later following section.
4.6 Risk and return
4.6.1 What are risk and return?
We like return and dislike risk, but risk is ever-present in all financial markets, and there is a positive
relationship between risk and return. In other words risk and return are opposite sides of the same coin.
We know what return is: capital gains / losses + income (dividends or interest), and it is usually measured
as holding period return42
(HPR):
HPR = [(P1
– P0
) + I] / P0
where: P0
= buying price; P1
= selling price; I = income.
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If annualised (AHPR):
AHPR = (1 + HPR)1/n
–1
where: n = years or fractions of a year.
But what is risk? It is the risk of the investment losing value (capital loss) or it not yielding an income
or both. This possibility is encapsulated in a measurable concept:
The probability of the actual return (HPR) on an investment being different from the expected
return (ER).
There are two broad sources of risk (that contribute to the probability of HPR being different from ER):
• Security-specific risk (aka unsystematic risk).
• Market risk (aka systematic risk).
Security-specific risk arises from the activities of the specific companies, and the industry of which they
are a part, and may be seen as the major factors that affect the income flows of companies. Analysts
generally categorise this risk-type into business risk (examples: prolonged labour strike, arrival of serious
competition from offshore, harmful management decisions, changes in product / service quality);
financial risk (when debt is utilised as a source of capital, and is used injudiciously by the company); and
liquidity risk (the risk of the segment of the share market in which the relevant share is being illiquid so
that fair market value cannot be obtained).
Market risk is made up of the risks that are inherent in the financial and/or economic system. This risk
affects all markets and little can be done about it. Examples of this type of risk are: tax changes, upward
changes in interest rates (interest rate risk), political instability (country risk), the declaration of a war
(country risk), a major change in the exchange rate (exchange rate risk), a change in inflation (inflation
risk).
4.6.2 Measuring risk and return
Measuring historical risk and return is straightforward, and it is best elucidated with an example using
annual figures. Return over a year is HPR, and risk is the standard deviation of returns. This is a measure
of the dispersion around the average return (= the arithmetic mean) in percentage terms. The formula is:
n
2
= (X – M)2
/ n - 1
i = 1

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where
σ2
= variance of a set of values
X = each value in the set
M = mean (i.e. arithmetic average) of the set (mean return)
n = number in the set
σ = (σ2
)1/2
(i.e. square root of σ2
) = standard deviation.
Table 2 shows the hypothetical HPR returns on a share for the years 1 to 4, and the relevant calculations.
Year HPR (%) X X – M (X – M)2
1 25 16.25 264.06
2 15 6.25 39.06
3 0 -8.75 76.56
4 -5 -13.75 189.06
M = 8.75 Σ (X – M)2
= 568.74
σ2
= 568.74 / 3 = 189.58
σ = (189.58)1/2
= 13.77%
Table 2: Calculation of historical standard deviation
This particular share has a mean return (M) of 8.75% and a standard deviation (σ) of 13.77%. It will be
obvious that the higher the standard deviation, the higher the percentage dispersion around the mean,
and therefore the higher the riskiness of this share.
4.6.3 Relationship between risk and return
Figure 9 demonstrates the relationship between risk and return, and it is evident that the relationship is
positive, i.e. the return required increases as risk increases. This is so because investors are risk averse.
The relationship is represented by what is termed the capital market line (CML which is used extensively
in portfolio literature). If investors were risk seeking (which would indicate a mental problem), the CML
would be negatively sloped. The slope of the CML depicts the extent of additional return expected /
required for additional each unit of risk assumed.

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Figure 9: relationship between risk and return
Risk= standard deviation
Expected
return
Capital market line (CML)
Risk-free rate (TB /
government bond rate)
All share index
Bonds
Figure 9: relationship between risk & return
There is ample empirical evidence this relationship: money market at bottom left, bonds in the middle
and shares top right. This is covered next.
4.6.4 Risk and return: the record
Fortunately, data is readily available on the risk and return relationship of the three main asset classes:
shares, bonds and cash (i.e. money market).43
Figure 10 shows the average annual returns and the standard deviations of the asset classes for a period
of over 100 years for South Africa. The evidence is indisputable: higher returns are accompanied by
higher risk (= dispersion around the mean return).
12.7%
6.7%
5.9%
23.2%
9.4%
5.7%
0%
5%
10%
15%
20%
25%
Equities Bonds Cash
Figure 10:RSA: average annualreturns & STD (108 years)
Average annual return
Standard deviation
Figure 10: RSA: average annual returns & STD (108 years)

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4.7.2 Efficient market hypothesis
The efficient market hypothesis (EMH) declares that financial markets are informationally efficient and
this means that investors cannot consistently achieve returns in excess of average market returns, because
all investors have and act on the same information.
The EMH is largely ignored in modern investment theory, and its remaining practical usefulness lies
therein that the participants in the market who act on new information and expected future information,
including the speculators, all contribute to price discovery (EPD), and market liquidity (ML, which
contributes to EPD). ML is important in that investors can buy or sell shares with ease, meaning with
no or little effect on market prices.
However, price discovery does not mean efficient price discovery in the sense of prices being “correct”.
There are vast differences at time between value and market prices, as we shall see later. Mr Dave Foord44
,
of Foord Asset Management, has the following views on the EMH:
“…we do not believe they are efficient at pricing securities. For evidence of this, look how often the
forward interest rate curve is wrong. Also, prices on some multi-billion dollar companies change by
more than 5% in a day with little or no material news flow. That is greater than the annual return on
US dollar cash in a single day!
“It’s important to understand that individual market participants have different time horizons. Probably
because of this, they have different valuations. Prices are set by the last seller and buyer. Often their
motivations have nothing to do with valuation. In fact, the majority of trade is for speculative purposes
and not for investment. Therefore the majority of trade does not take any account of the long-term value
of the asset. Why then should the price set by the marginal buyer and seller be correct for all?”

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Figures 15 and 16 demonstrate the principle. We have a two-asset portfolio made up of Share P and Share
Q. In Figure 15 their returns are positively correlated (correlation coefficient – COR = +0.98). The average
return is 25% pa and the standard deviation (STD) of the portfolio is 12.2%. In Figure 16 the shares’ returns
are negatively correlated (COR = -0.97). Note that the average return remains at 25% pa, but the STD is
now 2.0%. This is because the volatility of the average return around the mean return (25% pa) is lower.
According to the MPT it is possible to construct an efficient frontier of optimal portfolios that offer the
maximum possible expected return for a given level of risk, or the least risk for a given level of return.
The benefit of diversification is intuitive and is known in general parlance as “not putting all your eggs
into one basket”. This is a significant principle in investments.
4.7.4 Capital asset pricing model
The capital asset pricing model (CAPM) is an extension of MPT. It is a model that describes the relationship
between risk and expected return (positive as we have seen) and is used in the pricing of risky securities.
It says that investors in risky assets need to be compensated by two components (the total of which is
called the required rate of return – rrr): the time value of money in the form of the risk-free rate (rfr)
and a premium for risk (rp). The latter is calculated by a risk measure [beta, which is a measure of how
the share has performed relative to the return in the market (rm) of which it is a part] times the rp:
rrr = rfr + rp
= rfr + β(rm – rfr).
As we have said (and will further elucidate later), the CAPM formula is used in the valuation of shares
(i.e. risky assets).
4.7.5 Behavioural finance theory
Behavioural finance theory (BFT) proposes psychology-based influences to explain share market
incongruity [divergence between fair value prices (FVP) and market prices]. Conventional theories
such as EMH and CAPM assume that investors behave rationally, and emotions and other exogenous
influences do not influence investors. In other words, the conventional theories can explain rational
behavior in the financial markets, but the real world proves to be one in which participants often behave
irrationally and unpredictably.
BFT fills the gap, and it assumes that, in addition to market information, the personal characteristics of
participants (investors, speculators and arbitrageurs) influence their investment decisions and therefore
market outcomes – which cannot be explained by the EMH and CAPM. A manifestation of BFT is the
expression “herd behavior”.

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Figure 17 portrays the real world in respect of the asset markets: the market prices of assets (and
this applies especially to shares) much of the time are not equal to their FVP, but are related to this
underpinning factor, and generally reflect FVP on average over time. As we saw there are a number of
theories that describe this phenomenon of deviation from FVP, including the castle-in-the-air theory
and behavioural finance theory (BFT).
As said, the principle underlying asset valuation is the familiar FV-PV concept. A reminder is presented
in Figure 17. The asset has a cash flow in the future (FV) and is discounted to PV, which is the value of
the security now. The figure indicates just one interest payment in the future. When more are involved,
compounding enters the picture, and the formula changes slightly to [cp = compounding periods pa
(annually = 1, semi-annually = 2); y = number of years]:
PV = FV / (1 + ir/cp)y.cp
Figure 18: time value of money (FV to PV)
T+0 T+12 months
LCC 100 000
LCC 120 000
LCC 110 000
LCC 90 000
Value of
capital
Time
PV
= LCC 100 000
FV
= LCC 110 000
Discountrate of interest = 10% pa
PV = FV / [FV x (ir x t)]
= FV / [1 + (0.1 x 12/12)]
= FV / 1.1
= LCC 110 000 / 1.1
= LCC 100 000
Figure 18: time value of money (FV to PV)
In this section we cover:
• Valuation of shares.
• Valuation of fixed-interest securities.
• Valuation of futures and options.
• Valuation of income-producing property.
• Valuation of commodities.
• Valuation of other real assets.
• Valuation of participation interests.

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Figure 20: short-term banking rates & yield curve government securities
Interest
rate / ytm
(%)
1 day
Term to maturity
20 years10 years
Figure 20: short-term banking rates & yield curve for government securities
One-day
nominal rfr
Risk-free rates (marketable
government securities)
Call deposit rate – large deposits
Central bank repo rate
Bank prime lending rate
Interbank loan rate
Call deposit rate – small depositors
In the case of fee cash flow (FCF), assuming a constant growth rate in FCF (FCFg
) the formula is (WACC =
weighted average cost of capital):
PV = FCF × (1 + FCFg
) / (WACC – FCFg
).
Note the significance of the money market in the valuation of shares: the rfr. Figure 20 provides the
context of the rfr: it is all the points of the curve and the curve (called the yield curve and the term
structure of interest rates) is a representation of the relationship between the many rfr on the curve and
term to maturity at a specific time (i.e. it is like a snapshot). In the valuation of shares the 3-month rfr
is usually used.
4.7.6.3 Valuation of fixed-interest securities
Money market assets have less than a year to maturity and one interest payment. In this case the well
known formula applies (assumptions: t = 91 days to maturity, ir = 8.0% pa) (price per unit of 1.0):
PV = FV / [1 + (ir × t / 365)]
= 1.0 / (1 + (0.08 × 91 / 365)
= 1.0 / 1.0199452
= 0.9804448.

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For a 3-year bond (coupon payment = 1 = compounding period) the calculation is (coupon rate = cr =
9.0% pa; market rate = ytm = 8.0% pa) (price per unit of 1.0):
PV = [cr / (1 + ytm)1
] + [cr / (1 + ytm)2
] + [cr / (1 + ytm)3
] + [1 / (1 + ytm)3
]
= (0.09 / 1.08) + (0.09 / 1.166400) + (0.09 / 1.259712) + (1 / 1.259712)
= 0.08333333 + 0.07716049 + 0.0714449 + 0.79383224
= 1.02577096.
This is illustrated in Figure 21 (keep in mind that ytm = yield to maturity = the correct name for the
market rate in the case of bonds).
4.7.6.4 Valuation of futures and options
The TVM also applies in the case of futures. The FVP of a futures contract is equal to the spot price
(SP) of the underlying asset, plus the cost-of-carry or carry cost [financing cost (usually the risk free
rate46
is used here) plus other costs (OC) such as insurance and storage] (CC) less any income earned
(I) (CC – I = net carry cost, NCC) expressed as a proportion of the SP. This may be written as follows
(t = remaining term of contract in days / 365):
FVP = SP + {SP × [(CC – I) × t]}
= SP + [SP × (NCC × t)]
= SP × [1 + (NCC × t)].
Options pricing is more involved [because of the rights of the option holder (and no obligation), and
the term to expiry date] but one of the main inputs is the TVM.
4.7.6.5 Valuation of income-producing property
Inthecaseofrentalproperty,rentalincomeaftertax(FV)isdiscountedtoPVattheso-calledcapitalisation
rate. The latter = rfr + an appropriate risk premium.
4.7.6.6 Valuation of commodities
Because commodities do not have a recurring income (FVs), valuation is irrelevant. Their value is the
market prices at which they trade, and these are available at all times in the case of most commodities.
4.7.6.7 Valuation of other real assets
It will be recalled that “other real assets” includes real assets other than property and commodities, for
example antique furniture, rare stamps, rare books and art. The above comments apply, except that it
is not easy to establish prices, and this is so because the markets for them are not efficient, i.e. price
discovery is inefficient. The prices for these assets are usually established at auctions.

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4.7.6.8 Valuation of participation interests
As discussed, most individuals hold a large proportion of their assets in the form of their dwellings and
PIs in retirement funds (an investment vehicle). To the extent that they hold other financial investments,
these are usually in the form of the other investment vehicles, such as SUTs and ETFs. It will be recalled
that investment vehicles hold assets in the form of the ultimate investments: shares, bonds, money market
and real assets, and they issue PIs which are held by individuals in the main. The valuation of PIs reflects
the market prices of the ultimate investments mentioned. As these are usually available at all times, the
valuation of PIs are available at all times. Good examples are SUTs and ETFs.
4.8 Lessons from the theories and maxims
4.8.1 Introduction
The plethora of investment-related theories and maxims is evidence of the importance attached by
scholars to investments. While some of the theories have little empirical relevance, many of them have
elements that do. The following sections cover the useful elements of the theories and maxims (in our
view):
• There is no simple formula to make you wealthy.
• Top-down investing is wise.
• Diversification is critical.
• Base investment decisions on their FVP.
• Never fall in love with an investment.
• Do not be led by technical analysis.
• Be cognisant of behavioural finance (the psychology of the market).
• Appreciate market liquidity.
• Appreciate the life-cycle consumption theory.
• Appreciate the significance of the risk-free rate.
• Be aware of the principal-agent dilemma.
• Leave investing to the professionals.
• Understand macroeconomics and mean reversion.
4.8.2 There is no simple formula to make you wealthy
The only way to reach one’s FSG at a desired age is to ensure that I > E, i.e. to save and to invest wisely
over a long period. Dave Foord in this regard states: “To be successful at [investing] you need patience
and a long time horizon. And few investors have either.”

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4.8.3 Top-down investing is wise
Many fund managers are of the opinion that if you get the “big picture” right, i.e. accurately analyse and
forecast the international and domestic economic situation, and allocate funds to the asset classes in
appropriate slices, overall performance will be higher than the market average return.
A number of fund managers are of the opinion that up to 80% of performance is forthcoming from
accurate asset allocation. The proviso is that prime assets that offer value are bought.
4.8.4 Diversification is critical
As we have seen, appropriate diversification reduces risk. Diversify locally and internationally with the
emphasis on local. The reason for only allocating a small proportion (say 10–20%) to foreign investments
is that one’s liabilities are in the local currency. In this statement we assume a sound local currency.
In this regard Dave Foord49
states: “Diversification means reducing risk of loss by investing in a variety of
assets. A diversified portfolio as a whole will often display less risk than the least risky of the component
investments. Diversification is the only ‘free lunch’ available to investors. It is critically important in
risk reduction. Use it as often as possible, but not as much as possible, because too much diversification
reduces return (“diworsification”). Note that the more conviction you have, the less diversification you
need. Again, it comes down to one’s judgement of when and how much diversification to use.”
4.8.5 Base investment decisions on their FVP
Continually do your homework on the FVP of shares, buy the fairly-priced and underpriced assets and
sell the overpriced assets in the portfolio. Buy value shares as opposed to growth shares. Earnings are the
most significant element in investments: a number of the valuation techniques take earnings into account.
In this regard Dave Foord50
states: “All the valuation methods are good and should be used. They provide
a one dimensional number or valuation that can then be compared to the market price and a ranking
table of alternative investments. But this is not nearly enough. Two crucial aspects must be taken into
consideration. First, the quality of the business and its life expectancy should be used to judge the quality
of earnings. Second, the ability of management should not be overlooked. The range of management
ability is wider than most people think and these people are the custodians of the wealth of those who
invest in the company. Management needs to be trustworthy and capable of handling the risks and
identifying and acting on opportunities. Good judgment is required to make good investment decisions.”
4.8.6 Never fall in love with an investment
Allied to the aforementioned is the important maxim “never fall in love with an investment”. If an
investment is performing poorly, sell it, and remember the well-used maxim: “the first loss is the best loss”.

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According to Dave Foord51
: “We all make mistakes. Investment mistakes are expensive. Stubbornness is
not a good personality trait in this situation. In investing, the errors come fast and furiously, which is
strange, really, in a binary environment (there is only buy or sell and up or down). So you need to be
able to recognise mistakes early and then act to limit the damage. ‘Pay and the pain goes away’ is a good
motto that has often worked for us in these situations. We believe that a major part of Foord’s success
has come from risk management and, in particular, managing the risk of being wrong. How you manage
your mistakes will have a big impact on your investment result.”
4.8.7 Do not be led by technical analysis
Successful long-term investors do not rely on technical analysis (TA) as an analysis tool. TA can be
relied on for short-term gain only, because in the long-term intrinsic value (FVP) counts. TA only works
because of the existence of other technical analysts, who generally come to the same conclusions and
act on them. It is self-fulfilling in the short-term.
4.8.8 Be cognisant of behavioural finance (the psychology of the market)
Be cognisant of the fact that markets over-react and under-react to FVP (mean reversion: see below).
This can be taken advantage of, and is by the investments professionals. Individual investors should only
take advantage of this phenomenon if they are full-time investors. Full-time investors develop a “feel”
for the psychology of the market.
In this regard Dave Foord52
states: “Long before it became in vogue, it was evident to us that human
behavior made markets irrational and inefficient. If more than 75% of people believe they are above
average at a particular task, then a third of those people are wrong. So study human behaviour. Change
is a constant in the markets and people resist change; the older people get, the more they resist change.
One path to success is to be ahead of the curve of change. This is often a solo achievement as teams and
committees tend to resist change.
4.8.9 Appreciate market liquidity
Market liquidity refers to the extent of turnover in a share (or a market), i.e. the extent of buy and sell
orders in a share, and price discovery is linked to it. Never invest in a market or share that has low
liquidity, i.e. poor price discovery, because of the lack of ease of buying and selling when desired. Small
deals can have major price-effects in low liquidity markets. There is a reason for a share having low
liquidity: the share does not have the attention of the professional investors.

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4.8.10 Appreciate the life-cycle consumption theory
Be cognisant of the life-cycle consumption (and saving) theory, because reaching your FSG at a desired
age depends on adhering to the codes / rules of the four phases. As you are aware, this was given much
deserved attention in the first main section. It is mentioned here again because it is so significant (and
for the sake of completeness).
4.8.11 Appreciate the significance of the risk-free rate
An investment in government securities presents you with a return that is certain53
(the rfr). It is not
wise to accept a return on a risky asset that is equal to or lower than the rfr. Your required rate of return
(rrr) on a risky investment should be (rp = risk premium):
rrr = rfr + rp.
You need to decide on the rp, and it depends on the perceived risk.
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4.8.12 Be aware of the principal-agent dilemma
Any institution that has a portfolio (i.e. a principal) cannot offer objective advice, because its advice
is coloured by its portfolio. There are a number of examples of investment banks that sold shares to
individuals from their own portfolios, based on recommendations by them, because they wanted to
disinvest from them. In at least one case a class action against the bank was undertaken and won, leading
to reimbursement.
Thus, a bank or an insurer, for example, cannot give objective advice. The same applies to a broker-dealer
which has a portfolio, unless the broker-dealer is acting as an agent or is undertaking transactions itself
(dealing as a principal) that are proposed to you, and you are advised of this. Fund managers generally do
not hold their own assets, and if they do, they are prohibited from transacting in these assets with clients.
4.8.13 Leave investing to the professionals
Successful investing requires in-depth research, which is undertaken in-house by fund managers or
provided to them by broker-dealers in exchange for business (buy and sell deals for commission).
Individuals rarely have the resources to undertake the research.
If one does decide to invest oneself, it should be a full-time occupation, and deals should be conducted
through a broker that provides good research. The individual should also have a deep understanding
of macroeconomics and research this area of economics continually (see next section). There are many
individuals who are successful investors; all of them have a long-term investment horizon and undertake
in-depth research.
There are also many individuals who are content to “earn the market”, premised on the fact that few
fund managers are able to outperform what the overall market delivers in returns. Individuals can do
so by investing in investment vehicles, specifically ETFs which track the all-share (or similar) index.

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4.8.14 Understand macroeconomics and mean reversion
As said in the preceding section, if one undertakes investing oneself, security analysis and a deep study of
macroeconomics are important. We do not have the space to discuss macroeconomics here, and present
instead the essence of macroeconomics (elucidation of the acronyms was presented earlier):
• C + I = GDE
• GDE + X – M = GDP (expenditure on).
• X – M = TAB = part of current account of BoP (CA-BoP).
• Counterpart of CaBoP ≈ financial account of BoP (FaBoP).
• Forces of CaBoP and FaBoP = ∆exchange rate.
• ∆MV = ∆P × ∆RGDP.
• ∆M = ∆DBC + ∆FBC.
• Government expenditure > revenue = deficit (to be financed).
• ∆nominal GDP ≈ ∆company profits ≈ ∆FVP.
• Monetary policy and interest rates, which reflect and cause cycles.
Macroeconomics teaches us that there are economic cycles; they are innate and therefore inevitable.
They are caused by the interplay of the above-mentioned. On cycles Dave Foord54
offers: “You should
be aware that cycles do exist – they are a natural part of life, like the seasons, like the tides and like
breathing in and out. Economic cycles also exist and it is important that you recognise this as fact. We
find it surprising how many people still deny this. Standing in the way of market cycles, you will not
only suffer the ignominy of a King Canute but you will do yourself serious financial harm. Market cycles
are driven by interest rate cycles (valuation impact) and the business cycle (earnings impact). These two
cycles are interconnected, but not exclusively so.”
Thecyclesareanticipatedbymarkets,andmarketsover-reactandunder-react,dependingonmanyfactors
already mentioned, including human behaviour (mentioned before under the section on behavioural
finance), as shown in Figure 22. The cycles in the share market are clear, as is the fact that share prices
are extremely volatile in relation to nominal GDP. Notable in this chart is the average growth pa line: it
is the average growth in both GDP and the all share index. This indicates what is called mean-reversion:
in the long-term investment returns are linked to GDP growth (in nominal terms).

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Dave Foord55
in this regard says: “All investors should understand the concept of mean reversion…it
refers to the assumption that both the high and low points in a variable’s time series are temporary and
that the variable will tend to move towards the long run average over time. Mean reversion is not only
mathematically true (it has to be, in fact) but it can be used to good effect by investors. Because variables
often take a long time to revert, it provides time and opportunity to take advantage of mispricing evident
in the market.”
4.9 Portfolio management
There are many different types of portfolios / funds, some with legal constraints (such as the requirements
of the statute applying to retirement funds) and some without, and each requires a different style of
management. Examples are:
• Liability and asset portfolios
-- Banks
-- Insurers
-- Hedge funds
• Liability portfolios
-- Government
-- Company (when borrowing)
• Asset portfolios
-- Securities unit trusts
• Money market funds
• Bond funds
• Share funds (various)
-- Property unit trusts
-- Retirement funds
-- Individuals.
As we know, in the case of financial asset portfolios, the asset classes are money market, bonds and
shares. There are various strategies that can be employed in the three markets, as indicated in figures
23–25. (Unfortunately we do not have the space to detail them.)

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Figure 25: portfolio management: shares
PASSIVE
SHARE STRATEGIES
ACTIVE PASSIVE AND
ACTIVE
HYBRIDS
Buy and
hold
Tracking
an index
Total
replication
Investment
analysis
Style
investing
Core and satellite
Sampling Quadratic
optimisation
Customised
indices
Figure 25: portfolio management: shares
Passive management involves one or both of two management styles:
• Buy and hold. This is a style that involves buying chosen securities when funds are available
and holding them throughout bull and bear markets.
• Track an index. This amounts to buying ETFs and holding them, and is founded on the premise
that “the market knows better” or “I will not do better than the market”.
The D. E. Shaw group is hiring.
You can do the math.
Meet us on-campus this semester.
Check out www.deshaw.com for more info.

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Active management involves the undertaking of the three levels of research, as indicated in Figure 26,
and allocating funds, and buying and selling securities, according to the outcomes of the research. This
can be done by oneself or outsourced to a fund manager.
Hybrid management, also known as the “core and satellite” approach, involves the belief that “the market
knows better” for most of the time and therefore buying an overall market index (e.g. an all share index
ETF) with say 80% of funds, and allocating 20% oneself.
Foreign
financial markets
Money
market
Bond
market
Share
market
ANALYSIS OF DOMESTIC
MACROECONOMY
ANALYSIS OF INTERNATIONAL
ECONOMY
FINANCIALASSETCLASSALLOCATION
ASSET/ SECURITY SELECTION
INDUSTRY
ANALYSIS
OUTSOURCE
TO FOREIGN
FUND
MANAGER
SECURITY
ANALYSIS
NON-FINANCIAL
ASSETCLASS
ALLOCATION
Property
markets
Precious
metals
markets
Other
markets
Figure 26: investment analysis
Figure 26: investment analysis
A final word: the objective of investing is to achieve one’s FSG as soon as possible, and this entails much
more than just investing soundly. It involves conducting one’s life with recognition of the rules / codes
that apply to the four phases of the life-cycle., and allocating assets wisely over the life-cycle.

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4.10 Asset allocation over the life-cycle
4.10.1 Introduction
There is a body of literature called life-cycle investing. It holds that asset allocation should reflect one’s age,
i.e. that one should assume more risk at a young age (because risky assets furnish the highest returns,
and one has time to recover from poor decisions), and reduce risk as one ages. There is much truth in
this, but one should keep in mind that the time after reaching your FSG can be long indeed. Below we
present our views on asset allocation over the four phases of the life-cycle (assumption: the individual
is a successful employee or has a successful small business, and follows the rules expounded earlier). We
present Figure 27 as a reminder of the trends in income, expenditure, saving and debt over the life-cycle.
Income from
work
Expenditure
Saving
Age
0 20 40 60 80
This (compounded)
finances
Phase 1 Phase 2 Phase 3 Phase 4
Departure
for Heaven?
Income,
expenditure,
saving,
debt
Newborn to adulthood Adulthood to maturity Maturity to seniority Seniority to exodus Injury time
Figure 27: four phases of life-cycle
DEBT
(different
scale)
Figure 27: four phases of life-cycle
4.10.2 Phase 1: 0–20
In phase 1 the individual will usually have zero investment assets, except perhaps a bank account (money
market) in the latter part of this phase with minimal funds. Parents may have purchased a motor vehicle
for the individual, but this not an investment asset; it is a necessary lifestyle asset.
4.10.3 Phase 2: 20–40
Early in this phase the individual will be expelled from the nest, be employed, and income will rise
vertically from zero, reflecting the first salary. Expenditure will also rise vertically, but by less than
income, reflecting the contribution to a retirement fund (usually a defined contribution fund; not a
defined benefit fund). The contributions to these funds are tax deductable in most countries, and are
taxed on receipt of income upon retirement.

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As the individual progresses through the phase:
• Income will rise sharply.
• S/he will be married and have children.
• If both partners employed, income will rise to a higher level.
• Debt will be incurred for the purchase of a dwelling (a mortgage bond), which is the largest
debt the individual / family will incur.
• Expenditure (including debt service) will also rise, but less so, reflecting the contribution to
the retirement fund, as well as additional savings later on in the phase.
The additional savings may be invested as follows:
• In the asset class that delivers the highest return: shares. Risk is higher, but one has time on one’s
side: volatility is inversely proportional to the investment horizon (and the horizon is long).
• To accelerate repayment of the mortgage (assuming the mortgage agreement permits): it will
reduce the period of the mortgage. This is a particularly wise investment when interest rates
are high and share returns are low (taxation laws may influence the decision).
• In one’s own business, but only if one is a true entrepreneur. One has time to recover from
mistakes, which does not apply in the subsequent phases.
Asset class
Indirectly via
retirement fund
(% allocation)
Own investment
/ debt
Notes on own investment / debt
FINANCIAL ASSETS
Shares 75% 10% Indirect: ETFs and / or SUTs
Bonds 10% 0% Zero in this phase
Money market 8% 4% Direct: funds in bank account
REAL ASSETS
Property 5% 85% Direct: own dwelling
Commodities 2% 0% Zero in this phase
Other real assets 0% 1% Direct; small in this phase
DEBT Zero Large ± 60% of value of dwelling
NET ASSETS Positive Positive
Table 3: Example of portfolios: end of phase 2

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Consequently, the savings gap (I > E = S) widens sharply, allowing for a substantially higher level of
own (non-retirement fund) investment. At the end of Phase 3, the approximate portfolio of the family
could be as indicated in Table 4.
Asset class
Indirectly via
retirement fund
(% allocation)
Own investment
/ debt
Notes on own investment / debt
FINANCIAL ASSETS
Shares 75% 40% Indirect: ETFs and / or SUTs
Bonds 10% 5% Indirect: bond SUTs
Money market 8% 5%
Direct: funds in bank account
Indirect: money market SUTs
REAL ASSETS
Property 5% 40% Direct: own dwelling
Commodities 2% 5% Direct: gold coins
Other real assets 0% 5%
Direct: antique furniture, art, rare books &
stamps
DEBT Zero Zero Zero
NET ASSETS Positive Positive
Table 4: Example of portfolios: end of phase 3
Note the following:
• The asset allocation of the retirement fund is unchanged.
• The family has diversified its own investments between asset classes to a degree, but the
majority of financial assets are in shares. This is because the family continues to have a long
investment horizon.
• The proportion of property in the own portfolio, although still high, has fallen sharply, a result
of the allocation of savings to the other asset classes.
• The family’s investment in financial assets (exception = bank account): as in Phase 2, they
do not have the time to analyse shares and rely on the expertise of the fund managers of the
SUTs and ETFs.

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4.10.5 Phase 4: 60–80+
We assume that the two breadwinners decide to cease their active occupations at the start of Phase 4
and to pursue other interests, without income from these interests. They base this on having achieved
their FSG. This in turn is based on an analysis of their total portfolio, as indicated in Table 5. Here we
assume that the value their participation interest (PI) in the retirement fund is LCC 5 million and that
the value of their own portfolio is also LCC 5 million. Given these numbers, their total portfolio’s asset
allocation is as shown in the last column (ignore the bracketed figures).
Asset class
Indirectly via retirement fund
(% allocation)
Own investments TOTAL
FINANCIAL ASSETS
Shares 75% 40% (60%) 57.5% (67.5%)
Bonds 10% 5% 7.5%
Money market 8% 5% 6.5%
REAL ASSETS
Property 5% 40% (20%) 22.5% (12.5%)
Commodities 2% 5% 3.5%
Other real assets 0% 5% 2.5%
TOTAL 100% 100% 100%
Table 5: Example of total portfolio: start of phase 4
According to the retirement fund statute, they are obliged to purchase an annuity from a life assurer.
There are two main types: the traditional guaranteed annuity (which guarantees an income for life, but
has zero value at death) and the living annuity (which is subject to the vagaries of the markets, but has
a value at death which can be passed on to the children). As they have substantial assets, and wish the
children to inherit assets, they choose the living annuity. The statute obliges the annuitant to accept a
minimum annual income rate of 2.5% and a maximum rate of 17.5%. They choose 5%, because at this
rate, assuming a return on the portfolio of 10% pa, the income will only start reducing after 33 years.
They expect to live for another 25 years (to age 85), so they have a margin of safety. The living annuity
provides a taxable annual income of LCC 350 000 (assume LCC 245 000 after tax).
Age Annual annuity dividend Implied yield (annuity / LCC 5 million × 100)
60 LCC 479 940 9.60%
70 LCC 553 440 11.07%
80 LCC 634 140 12.68%
85 LCC 675 080 13.5%
Table 6: Annual guaranteed annuity dividends and implied yield at various ages

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However, the closer one gets to exodus, asset allocation shifting and timing become important. For
example, if one has 5–10 years to exodus, and the share market has had a good run for a few years, it
may be wise to shift the portfolio in the direction of low risk assets (bonds and money market assets).
Alternatively, if the share market has been low for an extended period (and one did not make a portfolio
shift before this period), it may be wise to keep the portfolio as is. It is a personal choice, and it makes
pertinent the study of macroeconomics, especially the interest rate cycle. The money market interest
rate is the denominator in security valuation calculations.
4.11 Bibliography
Bodie, ZVI, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.
Busetti, F, 2009. The effective investor. Johannesburg: Pan Macmillan.
Faure, AP and Ackerman, MPA, 2006a. Investment analysis. Cape Town: Quoin Institute (Pty) Limited.
Faure, AP and Ackerman, MPA, 2006b. Portfolio management. Cape Town: Quoin Institute (Pty)
Limited.
Foord, D, 2011. Time in the markets: lessons from the first 30 years. Cape Town: Foord Asset
Management.
Markowitz, H, 1952. Portfolio selection. Journal of Finance. 1, March. pp. 77–91.
Markowitz, H, 1959. Portfolio selection: efficient diversification of investments. New York: John Wiley.
Mayo, HB, 2003. Investments: an introduction. Ohio: Thomson South Western.
Michaud, R, 1998. Efficient asset management. Boston: Harvard Business School Press.
Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions 3e. Reading, Massachusetts:
Addison-Wesley.
Reilly, FK and Brown, KC, 2003. Investment analysis and portfolio analysis 7e. Ohio: Thomson South
Western.
Reilly, FK and Norton, EA, 2003. Investments 6e. Ohio: Thomson South Western.
Rose, PS, 2000. Money and capital markets Int.e. New York: McGraw-Hill Higher Education.
Sharpe, WF, 1964. Capital asset prices: a theory of market equilibrium under conditions of risk. Journal
of Finance. September. pp. 425–452.

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Endnotes
Endnotes
1. See Deaton, 2005.
2. There are many examples of individuals pursuing an occupation until over 90 years of age. In fact, there is
evidence to suggest that these individuals reach advanced ages because they have an occupation.
3. A term used by Marais in Marais, 2003.
4. A term used by Fourie in Fourie, 2004.
5. This section benefited much from: http://www.knowledgesutra.com/forums/topic/64677-4-stages-of-child-
cognitive-development/ and http://www.telacommunications.com/nutshell/stages.htm. [Accessed March
2012].
6. A term used by Marais in Marais, 2003.
7. Sue Grant-Marshall (in Fourie, et al., 2002:128) mentions the actions of a teacher who lined up school
children at the end of term according to grades. The emotional effect on the child (in terms of self-esteem)
who came last was devastating: “Imagine the psychological effect of that physical manifestation of ‘failure’,
one about which the teacher never failed to make a comment.”
8. Fourie, et al., 2002:131.
9. Fourie, et al., 2002:149.
10. Marais, 2003.
11. Note: this does not apply to everyone; there are cases where combination policies are appropriate.
12. Personal Finance, 2010. Buying the right risk life assurance. Cape Town: Independent Newspapers. 20
November.
13. Fourie, et al., 2002.
14. “Spend kids’ inheritance”, a favourite pastime of most parents, and so it should be. This means do not have
ambitions to become a trustafarian.
15. Fourie, et al., 2002:205.
16. Terminology used by Marais, 2003.
17. Inclusion suggested by Mega Parathyrus.
18. Oppenheimer, S, 2003. Out of Africa’s eden. Cape Town: Jonathan Ball Publishers.
19. Ware, B, 2011. Have no regrets: a life transformed by the dearly departing. Bloomington, IN: Balboa Press.
20. See The Economist, 2010:33-36. This publication refers to the NBER Working Paper: Subjective well-being,
income, economic development and growth.
21. Examples are Reserve Bank of Malawi bills, Bank of Botswana certificates, and South African Reserve bank
debentures. They can be regarded as a type of deposit security, hence the term negotiable certificates of
deposit (NCD) we use here for them. It is also done in the interests of simplicity.
22. In most countries this is so. In some, notes and/or coins are issued by the central government. Notes are
bearer deposit securities. We regard coins in the same light in the interests of pedagogy.
23. Many countries’ bond markets are OTC markets.
24. This differs from country to country. In most countries preference shares are redeemable at the option of
the issuer. Some countries have perpetual preference shares. Note that the term shareholders’ funds refers to
ordinary and preference shares plus the retained profits of the company.

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25. LCC is the currency code for fictitious country, Local Country (LC). The monetary unit is corona.
26. Also erroneously called the money supply. As we will see BD creation is the consequence of new bank loans
made. Therefore, a supply of bank loans exists, but not a “supply” of BD.
27. South Africa in this case.
28. The so-called cash reserve requirement (RR) does enter the picture here, but is ignored because not all
countries have a RR. The RR is often misconstrued / misused and confuses the process of money creation.
There is also little space to discuss this important issue here.
29. A yield curve is interest rates (called yield to maturity – ytm – in the case of bonds) on securities running
from one day to the longest term government bond, at a specific time. In other words, it is the relationship
between interest rates and term to maturity at a specific point in time.
30. A reminder: LCC is a fictitious currency: the “corona” of “Local Country”.
31. Please note that there is much overlap in this list, i.e. each bond is not necessarily a separate bond. For example,
a plain vanilla bond can be a registered bond or a bearer bond, a senior bond can also be a registered bond
or a bearer bond, a retail bond can be a plain vanilla bond, and so on.
32. The latter point benefited from Bradley, Higgins and Abey, 2000.
33. The classification is from Faure, AP, 2005. The commodity derivative markets. Cape Town: Quoin Institute.
It represents a personal view.
34. Except when they are used to cover a short sale (e.g. gold).
35. Because they cannot be held for long periods, and are subject to insect infestation – such as grain – which
increases the risk attached to the investment.

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Endnotes
36. In terms of which “contractual” amounts are paid (also lump sums); this is why insurance companies are
referred to as contractual intermediaries – CIs.
37. http://www.amex.com/?href=/etf/Glossary/Gloss.htm
38. Defaults do occur, but they are rare. Perhaps a better term is least-risky-rate (lrr).
39. We use these two terms interchangeably.
40. Actually on a “net” basis, but we are keeping it simple here. ∆M = ∆DBC + ∆FBC, should be: ∆M = ∆netDBC
+ ∆netFBC, i.e. after the deduction of government deposits in the case of DBC and foreign deposits/loans
in the case of FBC.
41. From an e-letter of Citadel Investment Services, “Think”, of 2 November 2006 to clients, entitled “The future
will surprise…again!”
42. There are also other measures: arithmetic mean return, geometric mean return, internal rate of return.
43. Source: Citadel.
44. Mr Dave Foord and Mr Liston Meintjies founded Foord Asset Management (FAM) in 1981. FAM has
achieved average returns of over 20% pa for clients over longer than 30 years. Mr Dave Foord is regarded
as one of the foremost authorities in the field of investments. See Foord, D, 2011.
45. It and its opposite, the castle-in-the-air theory, were originally postulated by Keynes.
46. In most derivatives’ formulae the risk free rate (rfr) is used, and this is so because it is a well known and
easily accessible rate. There is no standard definition for the rfr but most analysts / academics apply this
term to the 91-day treasury bill rate.
47. Foord, D, 2011.
48. The amount that bookmakers charge for their services is known as the vigorish. It is the amount they would
earn irrespective of the outcome of their wagers. The word is Yiddish slang and has its origins in the Russian
term for winnings, vyigrysh.
49. Foord, D, 2011.
50. Foord, D, 2011.
51. Foord, D, 2011.
52. Foord, D, 2011.
53. As we said before perhaps the rfr should be called the least-risky-rate (lrr). “Certain” applies if the asset is
held to maturity; otherwise market risk applies.
54. Foord, D, 2011.
55. Foord, D, 2011.
56. This text benefitted from: http://www.iol.co.za/business/personal-finance/news/how-to-choose-between-a-
guaranteed-annuity-and-a-living-one-1.998729 [Accessed on 16 February 2012].